Is a bubble building up in debt MFs?

'Indian non-bank lenders stand exposed to a deteriorating credit quality environment.'
'Such a deterioration could put at risk the value of NCDs purchased by the mutual funds and expose investors in bond and liquid funds to a risk of capital loss.'
Anup Roy reports.

Bonds issued by non-banking finance companies (NBFCs), being lapped up by the mutual fund (MF) industry could be pushing the investors and the financial system to a risky situation where capital loss could become a reality, a report by Ambit Capital has warned.

Terming the phenomenon as a 'bubble,' Ambit Capital CEO Saurabh Mukherjea said in the note that in the past three years, about Rs 3.7 lakh crore has entered the bond and liquid MFs, leading to a steady drop in bond rates.

Compared to this, equity MFs have received inflows of about Rs 2.3 lakh crore in these three years -- FY17, FY16 and FY 15.

Debt received more inflows in FY17 than the two previous years combined.

Liquid funds received about Rs 1.11 lakh crore in FY 17 till February and bond funds received Rs 1,95,300 crore in the same period.

Equity funds, till February, received Rs 74,400 crore.

Coupon on the three-month certificate of deposits (issued by banks) and commercial papers (issued by NBFCs and companies) of good firms have dropped to the level of the Reserve Bank of India's repo rate of 6.25 per cent, or even lower.

For example, RBI data show the rate of interest on commercial papers at the end of February had dropped to 6.08 per cent, from 8.04 per cent in February 2015.

The fall in the money market instruments in the past three years, therefore, have been more than the fall in RBI repo rate of 175 basis points.

'Naturally, therefore, there has been a surge in NCD (non-convertible debentures, or bonds) issuance by non-bank lenders over the past year in spite of a deterioration in the underlying fundamentals of these lenders,' Ambit said in a note.

The war on black money by the government is 'clearly taking a toll on the informal sector,' and 'Indian non-bank lenders stand exposed to a deteriorating credit quality environment. Such a deterioration could then put at risk the value of the NCDs purchased by the mutual funds and thus expose Indian investors in bond and liquid funds to a risk of capital loss.'

According to Ambit, in the five years from FY12 to FY16, NBFCs issued on average Rs 2,300 crore of NCDs.

'Then in FY17, with no underlying improvement in the health of these issuers or of the Indian economy, the NCD issuance by NBFCs jumped to Rs 3,200 crore whilst the cost of these funds fell (the average yields of AAA bonds, across maturities, declined by 80 bps (basis points) from 8.3 per cent in FY16 to 7.5 per cent in FY17).'

This is a 'peculiar pattern' as the return on assets of these lenders has fallen, but the quantum of NCDs issued by them has shot up.

NBFCs historically have assumed credit risks that banks did not want to undertake, for example in the micro, small and medium enterprises, where cash flows are not entirely shown accurately in their tax returns or lending to homeowners with irregular cash flows.

These are part of the informal economy in India, which is suffering a setback after the Centre's crackdown on black money.

Already, some of the NBFCs, especially those engaged in real estate funding, are suffering financially.

'However, as FY18 progresses further, these pressures will make themselves felt more widely. As that happens, a major correction in the NCD market seems inevitable. Such a correction obviously has grim implications for Indian mutual funds who have loaded up on the NCDs issued by the NBFCs,' Ambit said.

Photograph: Jo Yong-hak/Reuters