Morningstar's take on the FMP debacle

Fixed Maturity Plans are in the line of fire. But here is what we can all learn from this crisis of sorts.
By Larissa Fernand |  12-04-19 | 
 
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About the Author
Larissa Fernand is Website Editor for Morningstar.in. She would like to hear from you and welcomes your feedback.

Investors who were convinced that Fixed Maturity Plans, or FMPs, are a suitable alternative to bank fixed deposits, have got a rude jolt of reality. It’s evident now that “safe” is a very relative term, and nothing is “guaranteed” when it comes to a market-related investment, be it debt or equity or a hybrid.

Let’s replay the events that have caused such a furore in the fund industry this week.

What is an FMP?

FMPs are close-ended debt funds which invest in debt instruments such as commercial paper (CP), certificate of deposits (CD), corporate bonds and government securities (G-Secs).

The fund manager would align the maturity of the underlying investments with that of the fund. Which means, all the debt instruments purchased mature around the same time, which matches the maturity of the fund. On maturity of the individual instruments, the fund manager moves the proceeds into cash or cash equivalents and does not reinvest them. On the fund’s maturity date, the FMP is terminated and the money is returned to unitholders.

FMPs tended to have lower expense ratios when compared to debt funds and offer the benefit of indexation. The reason they are likened to a fixed deposit is because the investment had a fixed tenure, and the return could be gauged by the return of the underlying investments. However, it was not assured, as some were led to believe.

What is the current issue?

Kotak Mahindra Mutual Fund declared that investors of its FMPs plans would not be able to redeem their entire amount because of its exposure to the Essel Group. This was with reference to Kotak FMP Series 127 and 183. This would also apply to FMPs coming up for redemption in the near future.

HDFC Mutual Fund also announced plans to roll over one of its FMPs due for redemption next week. HDFC FMP 1168D MF Scheme maturing on April 15 gets extended by 380 days.

What led to this?

A number of fund houses had been lapping up paper issued by the Essel Group. Either for their open-ended debt funds or FMPs. Naturally, they have not been left unscathed.

Subhash Chandra had pledged a substantial portion of his shares in Essel Group’s Zee Entertainment Enterprises Ltd. and Dish TV India Ltd. against loans. This money was used to fund certain infrastructure projects as well as the acquisition of Videocon’s D2H business. In retrospect, disastrous investment decisions.

In November 2018, he announced that he would sell up to 50% of the promoter stake in Zee Entertainment. Soon his publicly traded companies began to see their share price topple.

The terms of the bond stated that if the equity-cover falls below a certain level (due to a fall in the share price), mutual funds could either demand a ‘top up’ of equity or sell the shares they already held.

On January 25, there was a sale of about Rs 200 crore worth of Zee Entertainment shares by certain lenders. This resulted in its share price spiralling downward, from Rs 400 to Rs 280. The remaining lenders sought not to convert the notional loss into an actual one. Hence, a standstill arrangement was agreed upon and extended up to September 30, 2019.

Based on the portfolios of December 2018, the overall mutual fund exposure to the Essel group was Rs 8,000 crores, of which, Rs 1,670 crores was held in close-ended funds like FMPs. Here are some specific exposures to FMPs:

  • Aditya Birla Sun Life: Rs 77 crore
  • DHFL Pramerica: Rs 7 crore
  • HDFC: Rs 902 crore
  • ICICI Prudential: Rs 121 crore
  • Kotak: Rs 381 crore
  • Reliance: Rs 185 crore

What is the fund house saying?

Nilesh Shah, managing director of Kotak Mahindra AMC, gave an interview to Bloomberg where he explained that given the circumstances, they have taken a call in the investors’ best interests. He also stated that all the money has been returned to the investor barring the exposure to the Essel Group.

We believe that instead of resorting to panic selling of shares, which would have resulted into much lower recovery than our dues, it is appropriate to give allowance of time to promoters and secure ourselves with better security and higher interest rates. This will work well for our unit holders.

Of course, unit holders haven’t received all the payment of their FMP on maturity but if they can afford a little bit of time or delay, we are quite hopeful they will recover all their dues.

We have 8 FMPs that have Essel group companies in their portfolios. In seven, we are returning more than the amount we had collected along with some appreciation. In one, we are returning about 0.6% less. Every single investor in all of those FMPs which have matured or are to mature, based on our current estimate, we have repaid principal along with some capital appreciation, except in one FMP.

This is a deferment of payment, not default of payment. This is an FMP where we have repaid all the proceeds to the investors other than our investments in Essel group promoted companies and ITNL. Otherwise, we shall be accused of selling shares so cheap that we are not working for the unit holders but for the buyers of the shares.

We have taken a personal guarantee of the promoters, where we have upside sharing if there is strategic sale in Zee. We are quite hopeful that they will be able to sell their assets in a reasonable and orderly fashion. Their assets are far more than the total borrowings, and they will be in a position to repay lenders. This is not a question where there are only liabilities and no assets, it is a question of liquidity mismatch.

What are Morningstar’s views?

Kaustubh Belapurkar, Morningstar India’s director of fund research, shares his perspective.

The last few years have bought to the fore often-ignored but some of the inherent risks associated with fixed income investing. Typically, the three major risks associated with debt funds are interest rate risk, liquidity risk and credit risk.

What markets have been experiencing in the recent times is the credit risk, wherein the debt securities of some of the companies (such as IL&FS, DHFL and Essel Group) were downgraded due to defaulting of delaying on their debt repayments due to their financial vulnerability and asset liability mismatches.

The direct impact of these events is on debt mutual funds which have invested in the securities issued by these stressed entities. Consequently, investors are a harried lot on seeing their returns diminishing in an investment avenue which for long they considered as relatively lower risk.

Kotak Mutual Fund will make part payment of the redemption proceeds of the other bond maturities but will hold back the payment for the stressed assets until a resolution is reached and the monies realized.

HDFC Mutual Fund has decided to roll over/extend the maturity of one of its FMPs due for maturity on April 15, 2019 by over a year. The scheme will now mature on April 29, 2020 if majority of the investors agree to the roll over. It’s important to note that the decision to rollover lies with each investor. If they choose not to rollover, they will most likely receive redemption proceeds of all the other bonds except the Essel bonds, which will only be paid out after a resolution is reached.

Given the sharp drop in the share prices on selling of a small quantity of pledged shares, panic selling of pledged shares would have further exacerbated the situation and resulted in sharp drawdowns in investor values. Lenders mutually agreeing not to invoke pledges was a prudent decision.

In such a scenario, the fund houses are not left with many options. The most obvious options are to either make part redemption payments to investors and balance after the stressed asset redemptions are realized or offer a rollover of the fund maturity, which is exactly what Kotak and HDFC are doing. Subsequently, Investors who have invested in FMPs which are yet to mature and have investments in these securities must brace themselves for a similar scenario until a resolution on the Essel group debt is reached.

On the positive side, Essel group has a strong brand and the promoters are taking measures to resolve the crises and pay the money back to lenders. While the intent is there, whether it materializes or not needs to be seen over time.

  • Action points for asset managers

Given that the decision to delay the repayment of the Essel bonds has been agreed upon, asset managers should proactively inform investors well in advance about part redemptions in FMPs that hold these bonds. This will help manage investor expectations as well as help investors plan their liquidity as appropriate.

Going ahead, it would be prudent for asset managers to relook at how such ‘loan against shares’ transactions are structured, especially by placing covenants around how much can a promoter pledge. Otherwise, in cases of over-pledged promoters, such collateral remains as paper collateral which cannot be enforced effectively when required.

  • Action points for investors

Such events do highlight the importance of understanding the investment proposition and its risk-reward profile before investing. Market linked investment avenues, whether equity or fixed income, carry risks. While they can generate pleasing results under favourable market conditions, they will suffer under unfavourable conditions. So, while the gains are of investors, so are the losses.

Finally, don’t consider debt fund’s as a risk-free investment avenue and do not confuse FMPs as substitutes for bank’s fixed deposits.

Add a Comment
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M M
Apr 15 2019 10:52 PM
Credit Rating agencies, Fund Manager and all those who mis sold must be held accountable and their remuneration must be clawed back immediately.
M M
Apr 15 2019 10:51 PM
This is not the first time #FMPs are crashing. A decade ago it happened. People forgot. New set of people/bakras were found and now they go through this. This article gives a feel that this is happening for the first time. You should recall history and write about earlier mess as well. Morning star should always mention that the risk in #FMP is far more than any other debt instrument, as far as the investor is concerned.
Shashidhar S
Apr 15 2019 10:48 PM
Two Questions
1. What type of risk is this ? Is this the credit risk which are associated pure with Fixed Income Securities or any other. Further, what are the chances that next year we will be better than what we are today ?
2. With regard to ITNL, many Fund houses invested because of the rating by the credit rating agencies. With blaming or without blaming the loser will be the Investor, but if we want to point for it, is the credit rating agencies or the Fund Managers who failed to do proper due diligence?
Pradeep D
Apr 14 2019 03:34 AM
Hello,
Action point for the Author- What are the possible endgames for this Zee issue?
1) Subash Chandra pays back the money by Sep 2019 by selling stake
2) Subash Chandra could not sell his stake by Sep 2019 and hence doesnt pay back.
What will be the impact on the stock itself in above cases?
I guess all will end well in case of 1)
But what if 2) happens? Can you throw some light?
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