IL&FS Crisis – Impact and Future Action for our Portfolios

Sanjiv Mehta  |  2018-09-26

Infrastructure Leasing & Financial Services Ltd was formed more than 30 years ago and has helped develop and finance projects worth 1.8 trillion rupees ($25 billion). IL&FS is one of India’s key shadow banks and provides financing to multiple infrastructure projects across India, including Chennai – Nashri tunnel – India’s longest road tunnel at 9 kilometers. It is a vast conglomerate, a pioneer of public private partnerships and has a portfolio of about 13,100 kilometers of roads. Shareholders include India’s largest insurer, Life Insurance Corp, its biggest lender, State Bank of India and Japan’s Orix Corp.

It’s run short of cash. There were shock waves through Indian credit markets when it began missing debt repayments last week. IL&FS has been affected by high short-term interest rates and a recent drying up of new infrastructure projects in India. Additionally, some of its ongoing construction projects, including roads and ports have faced cost overruns amid delays in land acquisition and approvals. Disputes over contracts have locked about 90 billion rupees of payments due from the government. Also Ravi Parthasarathy, who was CEO of IL&FS for almost three decades, stepped down for health reasons in July 2018. IL&FS Financial Services has about $500 million of repayment obligations over the next six months. Its debts total about $12.6 billion.

Credit default of a big entity always has contagion as a big risk. IL&FS had a rating of AAA which got severely downgraded to D when it defaulted. This is leading corporate investors (most of them have a policy of not investing in any paper less than AAA rating) – to withdraw. For example, they are asking debt mutual funds holding such paper for redemption. Mutual Funds are finding conditions to be illiquid but still have to provide money to the investor. One of the examples was DSP Credit Risk Fund Scheme – to raise cash they had no alternative but to sell Dewan Housing Finance (DHFL) debt paper at a discount. This paper had an interest rate of 9% but they could get buyers who were demanding 11%- implying that paper valued at Rs 100 was sold at Rs 82 ( there is inverse relationship between price and yield – if you buy a fixed coupon paper at a lower price, obviously you are earning higher interest rate). This adverse selling of DHFL led to the speculation that there are problems with the company.

Equity market got unsettled and brought DHFL shares down by 42%. They had to issue several statements saying that they were well funded and had no liquidity problems and the next trading day, the stock moved up by 15%.

The repayment crisis has resulted in increasing borrowing costs in India’s credit markets, with the average yield on one-year corporate notes jumping to the highest since 2015. It’s raising questions about the affordability of some of Prime Minister Modi’s infrastructure projects. Those include awarding works of around 20,000 kilometers of national highways and ring roads in 28 major cities this fiscal year. Additionally, it’s got investors worried about leverage at other shadow banks, prompting a surge in volatility among financial stocks.

The consensus amongst various experts is that it is not a Lehman moment for India referring to the crisis that rocked global financial markets in 2008 spurred by the default of the Lehman Brothers – a lender with highest rating at that time. They are of the opinion that risks are limited and contained. SBI Chairman Rajneesh Kumar says “The problem is being projected out of proportion. IL&FS has underlying assets. Whatever exposure we have, it’s at the SPV (special purpose vehicle) level which is ring-fenced. It’s a problem which can be solved. It’s not that the magnitude of the problem is such that it can’t be resolved. I’m optimistic about it. There’s no cause for concern. Some solution will have to be found out. We have much bigger problems in other sectors. Resolution will happen in the IL&FS. IL&FS will have to come out with a package.”
Quite a few fund managers are of the opinion that this is a problem of liquidity mismatch and not of insolvency.

India’s Moody’s unit says IL&FS is “vulnerable to a lumpy deterioration in asset quality.’’ It has cut the ratings on several IL&FS debt instruments to a level that signifies actual or imminent default. Therefore, rolling over debt won’t be easy.

However, IL&FS is categorized by the Reserve Bank of India as systemically important, meaning it’s less likely than a regular company to be allowed to fail.

Many powerful players have a deep interest in preventing the group’s collapse, including those blue-chip and sovereign-backed shareholders. According to Bloomberg Opinion columnist Andy Mukherjee, state-run Life Insurance Corp. — the group’s biggest shareholder — will probably have to rescue IL&FS before retail customers of money-market mutual funds turn wary.

IL&FS is seeking to raise more than $4.2 billion selling assets, according to an internal memo seen by Bloomberg. It’s also planning to raise the group’s share capital and bring in strategic partners in a timely manner.

RBI has announced open market operations creating additional liquidity of Rs.10000 crores. Finance Minister Arun Jaitley has said that the government will take all measures to ensure that adequate liquidity is maintained/provided to the NBFCs, Mutual Funds and SMEs.

It is quite possible that the market will remain jittery for a few weeks before settling down. Many experts feel that a further down move of 5% is quite possible. Oil prices have also crossed a level of $ 80/barrel.

However, it seems that in the case of IL&FS, government will have no alternative but to protect it whether directly or indirectly. That is many times referred to as similar to giving a put option to the financial markets. Put option means a right to sell at a particular price even if the market price is below that, thus indirectly providing immunity to investors against a market crash.

We have always advocated equity being allocated only for long term horizon since such challenges will always appear. That is the essence of financial planning which ensures that assets which are required for short term goals, for example contingency, are never deployed in the volatile asset classes. Resilience and holding power are keys to generating good returns in the equity market. A confluence of good and positive factors happens inevitably in an economy which is growing and has sound fundamentals. Therefore our recommendation is to just retain our existing positions and be ready to buy more if the market falls further. For short term investments, it is better to invest in liquid or short term debt funds where interest accrual is the main factor. For a horizon of 1-3 years, we can invest in balanced funds but not the aggressive equity oriented ones – category of equity savings schemes is a good option since equity derivatives are utilized to hedge positions.