The recent events regarding Infrastructure Leasing & Financial Services (IL&FS) feeling the heat of the downgrade has created a sense of panic in the Indian financial market.

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The rating agency ICRA downgraded IL&FS’ parent company from AA+ to BB and for its subsidiary IL&FS Energy from CARE from A+ to BB-. The rating of BB and below means the paper falls into the below investment grade category.

On the surface, a downgrade is enough to put selling pressure on a stock, but the need of the hour is to look beyond the tizzy and understand the impact of the downgrade.

Now, a number of investors have exposure to debt /debt-like (read preference shares) instruments of these two companies. The exposure to the company is in the form of direct debenture investment, investment through mutual funds, investment in the preference shares of the company, etc... to name few routes.

Investments of a mutual fund to IL&FS and various subsidiaries is around Rs 3,100 crore and the preference share outstanding is close to Rs 800 crore. In the case of mutual funds, there is an exposure by 10 asset management companies (AMC) in various companies of IL&FS group across FMPs (fixed maturity plans, ), liquid funds and credit risk funds.

However, an investor who has invested in a mutual fund need not worry much because:

The credit risk is diversified to some extent as they invest in over 30-40 securities in a single scheme.

Being highly regulated, they write down the investment value of the paper that is downgraded immediately to the extent of 25 percent. This means that the maximum loss on the net asset value (NAV) has already accounted for by the AMCs. In case the company does not default in its future obligations, the NAV will witness a rebound.

If you are ready to bear the immediate impact, then you have the option to liquidate your investment, as the AMC will honour the obligation irrespective of default/downgrade by a paper that they have invested into.

However, for direct debt investors, the scenario changes a little. If you have invested in the listed Debenture or the Preference share of the company, you have primarily taken (i) a single issuer risk without mostly understanding the nature of the business; (ii) cannot liquidate even though it is listed because there are only sellers of the paper that has just been downgraded.

If you look back, when JSPL was downgraded, two mutual funds - Franklin and ICICI - that had exposure to the issuer immediately wrote down the instrument value by 25 percent thus reducing the fund NAV.

For investors who stayed put with their exposure benefitted as after a few months, as Franklin managed to sell the paper in the secondary market (which would have been difficult for an individual investor).

ICICI, which held on to the paper, also benefitted as JSPL honoured its due on maturity. In both these instances, the investors benefitted by adopting the wait and watch policy instead of exiting the fund in panic.

If you take the larger picture, you need to keep the following factors in mind to ensure risks like these have minimal impact on your investment.

Firstly, take single issuer risk only after understanding the financial stability of the company and the nature of its business and keep tracking it on regular basis.

If you cannot do the above, then investing through mutual funds is the preferred option because the fund manager would have done his due research and analysis.

Before investing in a fund, check the following factors:

Diversification of the fund across issuers and papers – preferably the issuer level exposure should be maximum 10 percent.

Check the capability of the fund manager in understanding credits by analysing how many upgrades he witnessed in the papers after he invested into it versus how many downgrades.

Understanding the credit research process and the pedigree of the credit analyst/fund management team.

Ideally, have 4-5 less correlated funds in your portfolio.

Do not invest in close-ended funds, as you are bound by a stipulated time-frame and cannot exit if you wish to.

The impact of the downgrade on IL&FS is a classic example of giving into the market chaos instead of cautiously waiting to see in which direction the storm will head. If investors fall prey to such events, then there will be constant panic in the markets.

Feroze Azeez is deputy CEO of AnandRathi Private Wealth Management.

First Published:Sept 11, 2018 8:57 PM IST