(Warning: Long post.)

News floods the investment landscape about something strange in the land of debt funds. It turns out that:

a) Kotak Mutual Fund has an FMP maturing April 8, and they won’t be able to pay the full maturity amount. They will pay some now, and the remaining “later”.

b) HDFC Mutual Fund also has an FMP maturing soon. They will postpone the maturity of the fund if you so choose, by one year. But if you don’t vote to postpone, you will get the maturity value but a lesser amount than the NAV tells you.

Whoa, you think. How can I be paid lesser than NAV? Isn’t that the very concept of an NAV? Isn’t it supposed to reflect what I’m supposed to be paid when I exit?

Of course it is. And that’s why the mutual funds have had to take it on the chin for pretending it is not. Or rather, for ensuring it is not. But before that, let’s understand what the drama is all about.

### What are Fixed Maturity Plans?

These are special funds, sold as if they were replacement for multi year fixed deposits. The idea was:

• You bought a fund
• The fund bought some debt securities scheduled to mature in a certain period say 3 years.
• After three years, the fund gave you back the maturity amount minus their fees and all that.

The big selling point was indexation of gains. If you invest on, say, March 25 2016 for a 3 year plus 10 day FMP, then approximately around April 5, 2019, you would get money back.

But because your investment year was FY2015-16, and your exit year is FY2019-20, you get four years of indexation for inflation. (See our article on How to Calculate Long Term Capital Gains Tax)

Assume inflation was 5% a year, and you made 8% returns a year. For simplicity ignore compounding – so if you invested Rs. 100,000 it became Rs. 124,000, but inflation allows your cost to be indexed to 120,000 (5% for four years, assuming that was the rate)

So you’d then be taxed only on the excess 4,000 rupees, and twenty percent tax means about Rs. 800 is payable.

Effectively you made a return of 24,000 minus Rs. 800 tax = Rs. 23,200 = about 7.7% roughly speaking.

Making 7.7% post tax in an environment where a pre-tax return is 8% is very nice. Because if you got a fixed deposit at 8% you’d pay tax on the interest each year. At a 30% tax rate, your effective post tax return was 5.6% which is low compared to what the FMP was offering: 7.7%.

Yet, there was a problem: Risk and Liquidity. You didn’t know what the mutual fund would buy. And it provided you only an “indicative” return. So you would invest, but the risk was left to the fund manager.

Liquidity was the compulsory 3.1 year lock in, which means you couldn’t get out even if you wanted to. You just had to wait till the very end. Different FMPs have different lock in periods of course.

You might ask: Can’t you get the same tax benefit if you just buy a regular debt fund in March and sell it 3 years and x days later? The answer: Exactly. But you know what, the fees for an FMP are excellent. We’ll come to that.

### What has gone wrong?

First, when you give money to a fund that can lock in your investment for three years, they have the ability to put whatever they want into that fund. So you have to trust them. They can buy some awesome stuff. And then, they can buy some crap.

Turns out this particular Kotak FMP chose a little bit of both. Here’s the portfolio of this Kotak FMP (Number 183):

The yellow stuff is the really bad stuff today. But see the last line. They also had had 45 cr. in an IL&FS bond that has fully defaulted. It’s marked to zero. That’s also bad stuff. Both these weren’t as bad a few years back – things changed, and when they did, these investments turned bad.

The yellow stuff is by two companies:

• Konti Infopower (earlier called Continental Drugs)
• Edisons Utility Works

Both these are Zee promoter companies. Remember that Zee’s promoter, Subhash Chandra, has borrowed for reasons mostly unknown, through such companies. He has given Zee shares as collateral. Zee shares have been stable since 2015 – they were at Rs. 400 then (when the above bonds were issued) and they went all the way up to Rs. 615 before falling back to Rs. 418 on Friday.

We wrote about this more than 3 years ago: Read: Zee Promoter Company borrows 2,200 cr. , has no cash flows and Franklin MF owns 800 cr. of that debt.

### So The Collateral is Good? Wait, There is a Stand-Still Agreement.

But the stock has fallen all the way down to Rs. 250 as well. Because Subhash Chandra hasn’t just borrowed from one party – there are many lenders who have given them money against collateral of Zee shares, separately. One such set of lenders didn’t take kindly to not getting paid back, in January. And they dumped the shares they held, in the market.

Subhash Chandra’s promoter owned companies have a total debt of over 12,000 cr. But the lenders dumped only about Rs. 300 cr. worth shares in the market, in end-Jan, and the stocks absolutely tanked – falling over 50% at one time. Apparently you can’t sell 300 cr. of Zee shares in a day. This is a Nifty stock, so it doesn’t get any better than this.

Then, Chandra negotiated with all the lenders, including mutual funds like Kotak above, saying please don’t sell my stocks. You will just depress the price. Let me sell my stake to someone else, just half of it, and that should fetch me at least Rs. 20,000 cr. and then we’ll all be happy.

So they all decided to not sell shares until September 2019. And to not ask for money until then. This is the stand-still agreement people talk about.

However, this raises a specific question on bonds like the above. They are held in FMPs that mature. At maturity there is no money to pay because, hey, stand-still agreement.

### So These Bonds Have Defaulted? No Money?

This is where it gets tricky. The bonds haven’t paid out money. Yet, Kotak Mutual Fund needs to say there wasn’t a default. Because if it admits to a default, it has to mark those bonds down – to zero or 50% or something very low. And it continues to hold these bonds in other FMPs and funds too!

From Manoj Nagpal on twitter, we find the list of FMPs that Kotak alone has with exposure to the Zee Promoter group (Essel group) companies.

These are just the ones maturing soon – there are others, maturing later, that still have this exposure.

Kotak can’t admit there was a default, so it says: There was no default, but there’s not enough money either. So: we will pay you what we have, and the rest when we recover the rest of the money.

This might actually be decent for you, but it’s not that great for the system. Solutions later, but first, the other stuff.

### What were the Rating Agencies Doing?

Sleeping, or pretending to be. The bonds are rated by Brickworks, which is a rating agency, and by nature rating agencies are egregiously untrustworthy. But even among these rating agencies, who I repeat we should never trust, Brickworks is at the lowest end of the trust (or lack of trust scale). On a scale of 1 to 10, you might offer Crisil a minus 5, but Brickworks would be a minus 30.

Did I say we shouldn’t trust rating agencies? Mutual funds did. And do. Because that’s how a lot of them have to invest – by using ratings. You need at least an A, and you can’t do a BB, and a downgrade means you take a hit on NAV and so on.  And that is a failure of the regulator because they refuse to admit, even after a crisis of (name your religious big book) proportions, that rating agencies should not be trusted. And especially not so for regulatory limits – we should enforce that people who invest do their own thinking and have complete access to the data that rating agencies use.

Brickworks has come up with a phenomenal idea of keeping the bond rated at “A”. Which should mean “Adult” because apparently everyone’s not old enough (including Brickworks) to handle this security. But what it really means is: “Please let’s kick the can down the road”.

The rating release is here. It says that the bonds of Konti have been extended to September 30, 2019. Therefore they haven’t defaulted.

For Edisons, they say the same thing. But Edisons had defaulted on a bond on 22 March 2019. The rating is dated 10th April 2019. How can you put out a rating release after nearly 3 weeks saying that the bond has been extended? They are required to provide an update within a day or two – and they have been dinged in the past for delays of this sort. This isn’t them sleeping, really. They probably had to pretend to be asleep because if they didn’t, and rated the bond a “D”, then everyone owning this bond would have to mark it lower, which means taking losses in debt funds and oh man no one wants to go there again.

But this is exactly why the rating agencies exist. To provide that assessment where other players, who would normally be biased because they either own or issue the security, may not do the right thing. The rating agencies, however, are constrained because: Fees. If you do something like this, you won’t get paid in the future. And this isn’t peculiar to India, as this video tells us: (HT @apeksha2)

This is exactly similar:

• The Zee promoter has defaulted. I don’t care about this “extension” business; It’s a default and we should call it that. That’s a “D” rating.
• The rating agency should rate this a “C” at the very least. Because the bond’s not paying, and the collateral is NOT getting sold.
• And it’s not even like the collateral cannot be sold. Another lender likely sold about Rs. 400 cr. of Zee stock between February and March and that didn’t hurt the price. Sales can happen, even if over time.
• If the collateral can be sold and is not being sold, then it’s really the bond owner’s (read: the Mutual Funds’) problem. The rating agency needs to say boss, this is a default or close to it.
• Rating it C or D is the right signal. If people (such as mutual funds) still want to hold the bonds, it’s their right to do so – but the rating has to be shot.

If the rating agency is pretending that the bond is fine, that’s just dishonesty from the rating agency.

Let’s get this one straight. Don’t expect that in bond market investing you will make money all the time without losses. If someone missold to you the concept of an FMP as equal to a fixed deposit, then it’s an act of misselling and you must blame the intermediary. The fund house too, if it participated in such misselling.

But there is a risk in investing in debt funds. You are effectively lending to whoever the fund is lending to. A bank is different. It takes the risk on its balance sheet – you are isolated from it as a depositor (to a large extent, beyond which as a taxpayer you pay, but at least you get equity in the bank for it)

You need to understand that mutual funds have some risk at least. And it’s not that bad either. Look at this fund – this horribly 183 FMP from Kotak which has supposedly brought down the house. This is the chart of its performance.

It’s NAV is still Rs. 12.2878, which translates to 563 cr. in assets. Of this they can’t pay the Zee exposure which is about 104 cr. or roughly 20%. That means out of an NAV of 12.29, you will get a little bit less than Rs. 10. (It’s confirmed by @rvgandhi on twitter, who received Rs. 9.9591.)

You invested Rs. 10. This means that over 3.5 years you got only 96% of your money back – a 4% haircut. And there’s a chance you get another Rs. 2.xx after a few months. This is the “risk” part of investing – sometimes you win, sometimes you lose. At least here you only lost 4%.

This was not the only investment by the fund. There were others. Here’s how the fund looked when it started out:

There’s other investments in there, just as shady as the Zee one. MA Maulti Trade is another such trade that is lent to a promoter of Bajaj Corp against shares. That seems to have returned money well, but it could have hurt too if Bajaj’s promoter was in trouble. (There are many Bajaj’s. They don’t necessarily like each other. It’s complicated.)

So it really isn’t about making a bad choice of investments. Seems fair to have bet on a lot of things, but the real problem at the fund manager end comes in:

• They didn’t take action when things went bad. They had the collateral, and they decided not to sell it (the Zee shares). This is not a decision they should take by themselves – they only manage your money, and pass on the risk to you. The bad decision was to not build the consensus and to not offer a way out to at least exiting FMP investors. (In other funds, people can sell their units)
• Second, they didn’t mark down the Zee bonds. This is bordering on illegal. Think of a bank. It has a loan that they know for sure will not pay out for 6 more months – can it say it’s not an NPA? Because they have collateral? Many banks think otherwise, but in general, banks have to mark down the loan by 15% initially and call it an NPA (and stop accruing interest). The mutual fund here – Kotak – has to do the same thing – take a mark down and assume it will fail until it pays.
• Third, mutual funds have been too kind to low interest rate lending against shares. Banks can’t sell to them (they need higher covers and there are limits) and so it’s the NBFC + Mutual Funds that will be the buyers. But then, why lend only at 11%, and that too with a balloon payment? Zero Coupon bonds are a bad idea in such a case – because there is no need for intermediate cash flow. Even a dead body can sell you a zero coupon bond if all you will do is rollover at every maturity.
• Fourth, why such high concentration levels? We are seeing 20% in one group in some cases. I can understand this in open ended funds – where, because a lot of investors have exit, the remaining portfolio has concentration issues as the exits forced a fund to sell the liquid part of the portfolio. (The illiquid part becomes a relatively higher percentage). Even in equities such a high percentage would be scary but for a debt fund investing in an illiquid zero coupon bond of a company with no cash flows, putting 20% of a fund?

### And Why not HDFC?

Also I believe that Kotak has been skewered for this. But HDFC gets away easy. Why? It has about 1000 cr. in such instruments and it hasn’t even communicated properly. And HDFC AMC is a listed company. It’s horrible that we don’t expect the same explanations from the esteemed people at HDFC. SEBI in fact needs to come down even harder on the largest fund house in the country.

### What about ZEE Promoters? Can They Pay? Preference Share Payment Gone?

This is more a question of “do they want to pay?”. The Zee shares can be sold even now – even if it’s done in a phased manner.

There’s the question of money that’s come in, recently. Zee promoters have owned about 43% of a 2000 cr. Zee redeemable preference share. (We wrote a premium article on it) Of that, about 20% has been paid in March. Which should have given them Rs. 160 cr. That’s enough money to pay out at least what came due last month.

That they decided not to pay is a dangerous sign. They are taking advantage of this standstill agreement, and not even paying money they have received, and letting bonds go into default. Mutual funds must know this and demand a payment. (You have shares. They dilly dally, you sell. )

### Okay, Stop The Gyan. What Solutions?

As an investor you should plan to see this happen at least 5% of the time. Meaning, if you’ve invested Rs. 10 lakh then assume you will lose at least 50,000 at some point, in debt. It’s higher in equity, but you need an allowance for debt.

But what if you hold such FMPs?

• Assume you’ve lost the Zee promoter shares. The FMP 183 investors have it good – they still get 96% of their money back. Other FMPs will not. Let’s just assume that money is gone.
• FMP returns can’t be predicted even with an “indicative yield”. These have a risk. You’ll find that out very few years.
• Wait for the remaining money to come back. If it does it will pay out 11%, so you’re still compensated.

Here is a list of all troubled investments that have exposure to Zee Debt. (Thanks again to Manoj Nagpal and Morningstar) This has HDFC FMPs, Birla FMPs, ICICI FMPs and more. You might want to see which open ended funds you own, and maybe correct or change the exposure.

Going forward, the idea in making debt investments is: be ready for some risk. Funds in India are better regulated than banks – and will do a lot to ensure they maximize value for you. Kotak or HDFC can easily mark the bonds down to a low value and sell them to interested vulture funds at those low prices – and ensure you get some money back but not all. They’re choosing to try and get you paid in full after a while. This is noble, but it won’t always be the case; at some point, you will see funds selling out their bad investments and passing the loss to you. (That’s a good thing – you invested for liquidity at the end, not to pray to Lord Chandra to please return some of your money)

FMPs are useful to get this four year inflation indexation thingy. But you can do that with other funds too – open ended ones. All you do with FMPs is lock in commissions for X years, and ensure you can’t exit when you want to (and sometimes even exit when it’s due!). One reason to do FMPs is to reduce your interest rate risk for a very specific time period (three years etc) but most people have no idea when they need money, and its usually okay for them to stretch the investment a few years more. You don’t get this flexibility with FMPs. You have to take the money out, even if you don’t need it, and pay tax. If you aren’t sure you need the money in exactly three years and X days, then why buy an FMP? Just do a split between a liquid fund and a short term bond fund, and you should get a similar return.

That note is specifically for the “HNI” People whose advisors give them this advice for tax-saving purposes – putting long term money in a three year fixed term product is not a good way to save tax. It’s better to only pay tax when you need the money out of your investment.

HDFC is going to redeem current investors but have requested for an extension of the FMP for one more year. Some silly reason like they see good yields – but obviously this is to avoid having to reduce a payout like Kotak has.

You would be better served not extending the FMP and instead, take what you get. The rest if recovered will come later.

SEBI needs to look at the time frames and consent norms here. This seems altogether too sudden to inform investors of an extension.

### Should Mutual Funds Do Something Else?

There are unpalatable but workable solutions.

First, these fund can appropriate the shares for their other funds who will anyway need Zee exposure – A Nifty Fund, an Arbitrage fund and so on. You could take over the zee shares, and sell futures in an arb fund, and thus not even have to sell the shares in the market. If Subhash Chandra finds the money (or a buyer) you can then transfer those shares back if your arb fund still has them. Mr. Chandra won’t like this but it won’t cause damage to the share price, and it will give FMP Investors their money back.

Second, the funds can investigate what has happened to recent dividend and other repayments on ZEE preference shares, which was given to the Zee promoter, and should have provided for Rs. 160+ crores. The “intent” of a promoter may then become clearer.

Lastly, funds must work together to consider building out vulture funds instead, or use “Credit Risk” funds. You could for instance sell the Zee promoter debt at a 10% haircut – say Rs. 100 cr. instead of Rs. 110 cr. and pay investors back. They will still make, in Kotak’s 183 fund, about 6.27% annualized. Even if they fully recover the Zee Debt, it will be like 7% at the most.

(Why will a buyer buy? Hey, you have shares as collateral and the return is a ludicrous 30%+ rate – annualized – for 6 months! I would be happy to buy)

You can adjust these numbers but you know what I mean.

Note: Franklin did this with JSPL debt in 2016. It sold the bonds it owned at 30% discount. Later it turned out the AMC bought the funds by itself and the transaction got a bad name because they managed to recover the full money. (Read mint article) However that was the right thing to do – the bond funds needed the liquidity and to keep the bonds on the books meant they kept getting beaten up by investors for keeping a defaulting bonds on the books – at least they ensured recovery of 67%.

### Can the bonds be side-pocketed?

The new SEBI Side Pocket rules require a default and action to be taken within one day of default. Both haven’t happened. So technically, no.

But SEBI can still push through saying they want all this debt to be side pocketed across funds. And the investments can also then be sold, at a discount if required.

### What Should Rating Agencies Do?

Nothing. Please. Let’s just make them irrelevant. Maybe we can ask them for election results and bet the other way.

### Can SEBI Help?

SEBI is a blunt instrument. It will put rules that will change the functioning of the whole market, sometimes stunting it. It’s for players to come up with self regulatory solutions first – because otherwise bad behaviour will be punished hard, and even some good behaviour will be beaten up.

But SEBI does have a role:

• Ding the rating agency (Brickworks) for not taking rating action on Edison’s when it defaulted March 22.
• Tell funds to side pocket all Zee promoter debt that is at risk on a per-mutual-fund basis, and adjust NAVs accordingly. Funds will be relieved.
• Enforce concentration rules – why are FMPs having 20% in one promoter group?
• Ensure that mis-selling of FMPs is not done in terms of comparing them to three year fixed deposits.
• SEBI needs to do a better communication job than they are at the moment, because the silence is deafening.

### Can you please finish this post?

Yes.

Tweet out to @deepakshenoy for comments. Thanks to all the comments on twitter and a special mention to Manoj Nagpal.