How default leads to NAV crash in mutual funds

After debt-laden mortgage lender Dewan Housing Finance (DHFL) failed to pay on its bonds on Tuesday, net asset values (NAVs) of several debt funds - including those run by top MFs - crashed. On Wednesday, ratings agencies Crisil And ICRA downgraded commercial papers issued by the company. Here's the lowdown on the latest troubles in the debt fund segment and what can investors do to safeguard their money.

What's the DHFL crisis about?
The genesis of the DHFL crisis is systemic to the Indian debt market system rather than specific to the company. DHFL has substantial short-term loans to repay to holders of bonds and FDs, among others. The company has given home loans, advances against property and also lent to real estate developers, which usually take several years to be recovered. It needs to pay back some of its bond and FD holders, but most of its money is long-term loans. So it's now selling off parts of the businesses, like affordable housing finance company and mutual fund, to raise money to pay back bond and FD holders.

Why NAVs of debt funds fall drastically in case one of its portfolio companies default in payment on its bonds?


When the bonds issued by one firm forms a large portion of the fund's portfolio, a default in it leads to a crash in the NAV of its holding debt fund. This is because under Sebi rules, as soon as a company defaults, the bonds issued by it should be valued at 25% of its original value - that is, a 75% markdown. Over the next 15 days, rating agencies - Crisil and ICRA - are mandated to independently look into each bond issued by that company and give their opinion on the present value of those bonds that each fund manager is liable to accept.

What happens after the initial 75% markdown?
For example, a fund has Rs 100 crore worth of bonds issued by a company X, which defaults on its payment. The day the company X defaults, those bonds worth Rs 100 crore will be valued at Rs 25 crore (under Sebi rules). Now, if this debt scheme's total portfolio size was Rs 300 crore, the bonds of company X at Rs 100 crore formed 33% of its portfolio. With Rs 75 crore gone due to the downgrade, the scheme's NAV will fall by 25% in a single day. So the larger the holding of a bond in default, the bigger would be the fall in NAV on the day after the default.

How long does it take for the NAV to recover?
After the revaluation by rating agencies as mandated by Sebi, in most cases, the value of bonds in default are seen to be much higher than just 25% of their original (after the markdown). So investors could reasonably expect some smart recovery in NAVs after rating agencies give their valuation opinion.

Do NAVs of all funds recover?
In case the company is backed by sound business or assets, usually NAVs recoup their losses within 15 days. But a sharp recovery in NAVs does not happen in case of companies with no or bad assets. Mutual fund managers, however, don't invest in such companies in the first place.