BT Buzz: NBFC bubble -- Bursting in phases?

In the last three years, debt mutual funds had become the de-facto bankers to the fast-growing non-banking finance companies (NBFCs). They accounted for the bulk of the industry's growth capital as public sector banks pulled away from lending due to lack of capital. Now, the chicken has come home to roost as an increasing number of NBFCs face liquidity crunch after a sharp rise in interest cost has hit their repayment ability. The latest to join the red list are Anil Ambani group NBFCs -- Reliance Commercial Finance (RCF), Reliance Capital (RCL) and Reliance Home Finance (RHF) -- which have been downgraded by rating agencies CARE and ICRA.

NBFCs are India's shadow banking sector, well known for aggressive lending practices, especially for small and medium enterprises, home buyers and real estate developers, who have difficulty in borrowing from banks. Credit from the NBFC sector grew by 21 per cent year-on-year in FY18, when bank credit growth was around 10 per cent. But the inherent problem with NBFCs has been their reliance on short-term funding routes like commercial papers and resorting to rollovers to meet their long-term lending requirements.

"The structure of the Indian money market, where NBFCs and housing finance companies (HFCs) borrow short term money and finance long term assets does not make sense. We are halfway through the unwinding of this construct and in the six to seven months following the general elections, I fear that the remainder of this construct will also unwind," Saurabh Mukherjea, founder, Marcellus Investment Managers, told Business Today.

Liquidity woes to worsen

The problems with the NBFC sector began in September last year when the infrastructure finance company IL&FS defaulted on payments to banks, term deposits and failed to meet the commercial paper redemption obligations. It caused panic in the markets as it impacted banks, MFs as well as investors.

Since then, the source of funding for NBFCs has been drying up and they are finding it increasingly difficult to service repayment obligations.

The downgrading of Anil Ambani group companies follows redemption delay by two fund houses -- Kotak Mahindra Asset Management and HDFC Mutual Fund - in April this year. The two MFs said they will not be able to redeem all their units due to delay in recovering money lent to the Subhash Chandra-led Essel Group companies.

"Now, there will be a certain set of companies, which will just not get lending due to their weak balance sheets. Asset quality consciousness is coming now and fund managers are no more chasing only numbers. So availability of liquidity will go down," says Jharna Agarwal, Head - Products, Preferred Business, at Anand Rathi.

Liquidity will be impacted more than the cost of funding because if a lender does not find a company making it to the cut, they will just not lend now. "No amount of interest rate will be enough for lending in such cases," she adds.

UR Bhat, Managing Director at Dalton Capital Advisors (India), says NBFCs have been going through turmoil. "This has been building up because MFs have lent to some companies where the group is facing problems."

And this is precisely the case with Essel Group where Chandra has sought time till September 2019 to repay debts. In all, MFs have an exposure of Rs 5,710 crore to various Essel Group companies through 133 schemes, as per data from Value Research.

Stressed and stretched

According to Credit Suisse, up to 15 per cent of debt mutual funds' assets under management are accounted for by four stressed companies - Dewan Housing Finance, Essel group, IL&FS and Anil Ambani group. These four companies together owed Rs 3.6 lakh crore to lenders in the end of March 2018.

A large part of this debt is sitting on the books of mutual funds and analysts fear that MFs may find it difficult to recover their money on time as well as in full. "Mutual funds have significant exposure to some of the stressed companies (Dewan, Essel, IL&FS & ADA Group), accounting for 4-15 per cent of AUM for some of the AMCs. In addition to the MF exposure, the exposure to four stressed groups for the banks and NBFCs is large, at 1 to 6 per cent of loans and 10-50 per cent of net worth," Credit Suisse said in a report.

Lenders with significant exposures to these entities are IndusInd Bank, Yes Bank, L&T Finance and Edelweiss, it added. Altogether, debt MFs have an exposure of around Rs 76,000 crore to the struggling NBFC sector, making them one of the biggest sources of funds for industry, according to Value Research. Now, with the risk of defaults increasing by the day, investors are in a panic mode, much like the lenders.

Bhat says it is obvious for investors to worry because when a downgrade or fear of default arises, there is an immediate fall in net asset value (NAV) due to mark-to-market losses. "There will be redemption fear. And while some would be fixed maturity plans, there is a bigger risk of redemption in the open-ended schemes due to decrease in NAV," he says.

On April 27, CARE Ratings downgraded RCF's long-term bank facilities worth Rs12,700 crore from CARE 'BBB+' to Care D. A 'D' rating implies instruments in this category are either in default or expected to soon be in default. CARE also downgraded Rs 5,000 crore worth debt of RCF to CARE 'C' from 'BBB+'. Instruments with a 'C' rating are considered to have a very high risk of default regarding timely servicing of financial obligations.

CARE also downgraded Rs 4,980 crore long term debt of RHF from CARE 'BBB+' to D. While debt mutual funds have an exposure of Rs 698 crore to RCF, the number for RHF is Rs 1872 crore, according to Value Research. This raises questions over the ability of mutual funds to pay redemption amount to investors given the high risk of default by both the companies.

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Panic mode

"If companies are downgraded, they do have mark-to-market losses. What was looking good till yesterday, can look bad now. It is obviously a sign of panic for investors who have exposure to such companies," Agarwal adds.

Bhat also believes that fixed income funds must invest in NCDs, which have underlying cash flows. "There is a technical argument that MFs should not have invested in the first place in promoter's funding because these businesses don't have cash flows for redemption. In case of a crisis, either the promoter has to get cash or there is a high risk of default," he points out.

Investors, in these cases, had put money in debt mutual funds or money market MFs. However, if there is lending to promoters against shares, fund managers are taking an equity risk while positioning the fund as a debt fund. They are then not being true to the label of a debt MF by investing in debt structure with equity risk, he says.

Madan Sabnavis, the chief economist at CARE Ratings, says companies which have run up a lot of leverage are facing problems. "When you have taken a lot of debt and are not able to perform, the problem arises," he says. But then what is the way out for investors? "Where mutual funds will invest is the decision of the fund manager. Investments in a liquid or government bond fund give lower return but are secure. Returns tend to increase with lower rated funds," says Sabnavis.

"But investors don't have much of a choice if certain debt schemes are not able to give desired results. They can go for the security of a bank deposit if it suits their risk appetite," he adds.

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