Investing in Debt Schemes with JSPL Exposure, Boon or Bane?

 

I had written four articles during debt market turmoil that erupted during Amtek Auto default & JSPL Downgrade. These articles titled: “Stay Away from Chinese Whispers” spoke about why one should not indulge in Chinese Whispers, lose talks & get swayed by negativity created by media or Twitteratis; second one on “Can We Rely on Credit Rating Agencies?” spoke about the role of Credit Rating agencies in Amtek Auto default fiasco when one of the schemes of J P Morgan had this exposure & the rating agency still continued to give AAA rating at the scheme level; third one titled: “Debt Market Investing in Equity Parlance” where I had compared Large Cap Equity to Income & G Sec funds & Mid & Small Cap Equity schemes with Credit or Accrual Schemes in debt markets & given some analysis based on these comparisons for easy understanding; & the last one titled : “Lull After Self-Created Storm”  wherein I had spoken about how life is normal for investors who would have weathered the storm of Amtek Auto default & JSPL Downgrade. I do wish to take some credit for bringing sanity back into debt markets; otherwise credit issue may or may not have happened – but we would have created a liquidity issue (like the one which happened with Mirae AMC during 2008 Lehman Brother crisis time).

Having said the above, I tried to identify AMCs which still has JSPL exposure in their debt schemes (in accrual schemes & not FMPs) & came across one such scheme which is ICICI Prudential Regular Saving Fund (RSF). They had an exposure of approx.3% of the scheme corpus before JSPL got downgraded to “D” in March 2016. Thanks to this, valuation of JSPL came down to 75% in February 2016 & finally to 67.50% in March 2016. Due to which 3% exposure came down to 2% currently.

Many people view this as a negative for taking fresh exposure to this scheme. However, I look at this as an opportunity for investments by investors going forward. Let me share why I feel this way:

JSPL Debt Exposure

First let’s understand the full implications of outstanding debt of JSPL. Company has almost Rs.46,000 crores of outstanding debt – which looks humongous. However, if we break this into different parts & segments, one will understand the full implication. Of this Rs.46,000 crores of debt, almost Rs.24,000 crores is for subsidiaries of the Company in different countries like Mauritius, Australia, etc. These debts are backed by their own assets & has very little impact on cash flows in Indian context. Rs.3,000 crores of debt is outstanding in capital markets with Mutual Funds & Insurance companies. So far the Company has not defaulted on servicing both interest payments as well as repayments of maturities on this debt. As recent as April 2016, the Company has repaid capital market outstanding on the due date.

How does an Investor make money in this Adversity?

ICICI Prudential RSF who had 3% exposure in JSPL NCDs had marked this down & valued it at 67.50% post the downgrade to D by the rating agency. This has increased the YTM on JSPL NCD to a staggering 25-26% & overall portfolio YTM from 9.40% to 9.80%.

What are the strategies behind some of these Accrual Schemes?

Most accrual schemes use two strategies viz:

1. Hold to Maturity (HTM) &
2. Roll Down Strategy

Hold to Maturity

When a Fund Manager buys a debt security of say 12 months, 24 months duration & holds it till maturity, it is called HTM security. Returns = Coupon – Expense ratios. Typically all Fixed Maturity Plans (FMPs) follow this strategy.

Roll Down Strategy

When a Fund Manager buys say 18 month paper, post 12 months get over it is supposed to have rolled down to 6 month in residual maturity. Similarly a 36 month paper, post 24 months has rolled down to 12 month in residual maturity. This strategy works very well in a steep or a stable yield curve where the returns = Accrual + Capital gains or Accrual – Capital loss (if the yield curve is inverted)

How does Roll Down strategy generate Capital Gains?

Typically, in a steep yield curve scenario, longer dated paper has a higher coupon attached to it than shorter duration. Like in the above example:

If 18 month paper has 10% coupon, 12 month would have 9% coupon & 6 month paper even lower at say 8% coupon. Post 12 months, 18 month paper as explained above has Rolled Down to 6 month in residual maturity. Hence, when a Fund Manager sells this paper or does MTM on this paper, the said security which had 10% coupon attached to it & currently has to be sold as a 6 month paper (which in the above example has a coupon of 8%) will generate capital gains of 2%.

If the yield curve is inverted then the same 18 month paper may generate capital loss.

So how does an investor generate returns in a strategy which combines HTM + Roll Down

Let’s assume that the debt scheme has 12 month in exit load, then the Fund Manager in a steep yield curve scenario (as shown in the example above) will create the following breakup of the portfolio between HTM + Roll Down papers:

Hence, as can be seen from above, in most cases (where Roll Down generates capital gains) returns of the investor will be typically higher than the captured Net YTM as there will be accrual on the entire portfolio from both 12 & 18 month papers & there will be capital gains on 18 month paper which would have rolled down to 6 month in residual maturity.

Alternately, if there is a small capital loss on the Roll Down strategy (due to inverted yield curve), overall accrual is substantial enough not to let investors return go in negative over investment horizon (in this example 12 months due to exit load issue) but it will work more like a formula:

YTM – Expense Ration +/- 100/200 bps. That is to say if YTM is say 10%, expense ratio is 1% = Net YTM = 9%. In a steep yield curve scenario the said scheme can generate 100 bps higher than net YTM = 10% or if the yield curve is inverted then the returns can be 200 bps lower than the net YTM = 7%.

Hence, now an investor has a returns band from 7% on the lower side to 10% on the higher side; which can then be compared with FD both on pretax & post tax basis.

As explained above, due to marked down on the value of JSPL paper to 67.5% of its original value & assuming further that JSPL honors its commitment on the maturity date viz. August 2019 – this security would then be valued at Rs.100 (from the current valuation of Rs.67.50); YTM on JSPL paper has gone upto 25-26%; thereby increasing overall Portfolio yield from 9.40% to 9.80%. Assuming an expense ratio of 1.50% = Net YTM of 8.30%. If the yield curve remains steep over the next 3 years & interest rates soften from hereon; the investor should expect 100-150 bps higher returns than the net YTM of 8.30% = 9.30% to 9.80% over the next 3 years with Indexation benefit & Long Term Gains tax @20%.

Other scenario is that since JSPL has not defaulted on their Capital Market exposures so far & assuming further that steel prices improve, Company EBIDTA improves & the Rating Agencies upgrade this paper from D to a higher level; there will be an immediate uptick in the valuation of the said paper giving a boost to the NAV of the scheme (even earlier than 3 years before its maturity in August 2019).

In the worst case scenario, if JSPL actually defaults on the maturity date; since the security has already been marked down to 67.50% & with overall exposure also having been brought down (due to valuation) to 2%; overall impact on the portfolio will be miniscule of 0.33-0.50% on the negative side. Hence, if the net YTM currently is say 8.30% as shown above, & with the assumption of default by JSPL; an investor can, in the worst case scenario earn between 7.75% to 8% over the next 3 years.

Following chart of actual returns will throw some more light on how this scheme has performed over different 3 year periods. Of specific importance for investors should be the highlighted returns period from March 2013 to March 2016 (month in which JSPL was downgraded to D):
 

Month	YTM	Exp Ratio	YTM-Exp Ratio	Purchase Date	Redemption Date	Actual 3 Yrs Returns	Difference
Jun-12	10.19	1.55	8.64	29-Jun-12	30-Jun-15	10.17	1.53
Jul-12	10.02	1.55	8.47	31-Jul-12	31-Jul-15	10.27	1.8
Aug-12	9.87	1.55	8.32	31-Aug-12	31-Aug-15	10.26	1.94
Sep-12	9.63	1.55	8.08	28-Sep-12	30-Sep-15	10.21	2.13
Oct-12	9.51	1.55	7.96	31-Oct-12	30-Oct-15	10.22	2.26
Nov-12	9.56	1.55	8.01	30-Nov-12	30-Nov-15	10.11	2.1
Dec-12	9.61	1.55	8.06	31-Dec-12	31-Dec-15	10.01	1.95
Jan-13	9.64	1.55	8.09	31-Jan-13	29-Jan-16	9.84	1.75
Feb-13	10.04	1.55	8.49	28-Feb-13	29-Feb-16	9.51	1.02
Mar-13	9.79	1.55	8.24	28-Mar-13	31-Mar-16	9.62	1.38
Apr-13	9.63	1.55	8.08	30-Apr-13	29-Apr-16	9.52	1.44
May-13	9.45	1.55	7.9	31-May-13	31-May-16	9.35	1.45
Jun-13	9.61	1.55	8.06	28-Jun-13	30-Jun-16	9.62	1.56
Jul-13	11.64	1.55	10.09	31-Jul-13	29-Jul-16	11.1	1.01

As one can see, during these last 3 year periods starting 2012, interest rates have softened & hence the scheme has generated better returns than the captured net YTMs at the time of investments. Even post downgrade of JSPL to D & its subsequent valuation at 67.5%; the scheme has generated 138 bps higher than the net captured YTM of  8.24% at the time of investment 3 years prior.

Advisors must first understand the concepts & strategies behind construction of some of these accrual schemes to understand full implications of such credit events. Instead of panicking at such times, one needs to think calmly, understand full implication on the overall portfolio, % of exposure in the portfolio, possibility of losing the entire value of such papers & its implications & possibility of upgrades or revival & its positive impact for the investors & many times take such contrarian calls which can be an Opportunity in Adversity.

Those who wish to see this note on a video format may click here

---