DHFL default crisis: The choices that remain for mutual fund investors

Association of Mutual Funds of India (Amfi) circular on valuations says AMCs have to mark down the value by 75 percent if a 'financial institution' is downgraded to 'D' rating. June 5 NAVs of most mutual funds reflected this in a sharp drop of 3-50 percent. Some of the smaller AMCs published their NAVs the next day (June 5) citing difficulty in assessing valuation given the sudden development.

For retail investors who were already reeling under the IL&FS and Essel Group impact, DHFL has come as a big blow and many are left wondering if complete redemption is the only solution.

Here, mutual fund advisors suggest that retail investors stay put. Why's that? Well, whatever loss the schemes are facing is as yet a 'notional loss' and the possibility exists that some recovery may be made. By exiting the investments today, investors will be converting this 'notional loss' into a 'real loss'. Given below is just a small excerpt of what is a long list of NAV cuts.

In the case of DHFL, if the company repays its liabilities within the grace period then AMCs may begin marking up some portion of the NAVs but the journey back up will be nowhere as swift as the one down.

Kaustubh Belapurkar of Morningstar India says, "AMCs will wait for clarity on future repayment ability of DHFL and visibility on cash flow situation before they bring the NAV back to its original status. Given the HDFL redemptions due again this week, AMCs will use a very graded approach to increase NAVs back."

According to Manoj Nagpal of Outlook Asia Capital, even if NAVs increase, the principal amount would still be at risk. “AMCs who hold DHFL bonds other than the ones where repayment is done will continue to keep the NAV lower," he noted.

As things stand, a few AMCs which have taken a big hit have stopped accepting fresh inflows into the affected schemes.

So, should DHFL make good of its current liability, will the credit rating go back to investment grade and life return to normal? Again, regulators and rating agencies do not view it so simplistically. Sebi advises rating agencies to wait up to three months before restoring ratings in events like this. Even after that three-month period, the rating may be revised back to 'C' or 'B', but not 'BBB'.

So, the road ahead is certainly not easy for DHFL or the AMCs and certainly not for the investors.

The natural repercussion will be felt in the mutual fund inflows which have already been dwindling over the last two months. Whatever money came in post the election results is likely to also be under pressure.

All told, there are no easy answers for all concerned. In the past year, investors have received several reminders that 'mutual funds are subject to risk'. While that may be so, the responsibility does rest with the fund managers who need to review the mechanisms they employ to judge credit quality.