How NPA affects your portfolio – an investor enquiry

As you all know, FundsIndia operates an open access advisory channel for all our customers. Occasionally, we receive a query that is so topical and useful that we want to share the answer with a larger audience. With the permission of the person who asked the question, we’d like to start a process whereby we share such questions and answers.

This blog post is first such effort. Following is the query and the answer provided by Vidya.

Question: I would like to know how the NPAs in Banks or financial institutions would affect the debt funds, as these funds eventually lend out money to the institutions and banks for a return. I know to some exte`nt that these would be MTM everyday in the NAV if some loans is not recoverable, but would like to know:

1. If the NPA is reflected in the NAVs on day to day basis.
2. How can you protect yourself from NPAs affecting your portfolio, I understand diversification, is there any other ways.
3. Just like banks negotiate the terms with the borrowers and extend for these loans, would the debt MF also do it with their borrowers.
4. In worst case scenario, if the NPA becomes totally unrecoverable, who will get the money first and the order how its disbursed when the borrowed company is diluted.

Response: Thank you for writing to us.

First, NPA is a term used by banks. An instrument may be downgraded but still be a performing asset where dues are repaid on time. Hence rather than focussing on NPAs, focus on rating and their movements may be important in the debt market.

1. Mutual funds‘ exposure to banks is through certificates of deposits. If the certificates of deposits are traded, higher risk in a particular instrument will be reflected through higher yields (and consequent price fall) in the instrument and thus captured in the NAV. In case of untraded securities a mark to market loss may be provided in exceptional circumstances, based on rating house valuations (crisil, Icra) which provide a value everyday for these securities. In case the fund is invested in corporate bonds – and the companies defaulting on their loan, their credit rating (for borrowing) comes down, thus reflecting in their yields. NAV prices therefore reflect this.

2. If you are invested in a debt fund, it is the debt manager’s job to protect the portfolio and make suitable changes. if you see your fund under perform terribly compared with similar peers, you may then choose to move out. That is at best, what a retail investor can do, since he cannot monitor the everyday changes made to a debt portfolio. In general, going for lower tenure funds helps reduce uncertainty not only in interest rate movements but also credit risk. Besides, one can look at reducing exposure to funds that take higher credit risks by going for lower rated instruments (of course the risk and return proposition is higher in such cases).

3. Yes, debt funds have various covenants that help protect their holding in case of downgraded. Often times, money is recoverable, especially if held to maturity. Many of them exit in the market and in some cases, fresh instruments with higher returns may be resorted to. This happened with FMPs that invested in real estate in 2007-08.

4. The quantum of recoverability will depend on whether the instrument is secured or unsecured and whether it has a first charge or second or otherwise on the assets. Accordingly, proportionate share may be received.