Ever since Cobrapost made its sensational financial scam allegations against Dewan Housing Finance in January this year, the DHFL saga has unfurled like a prime-time mega serial, with so many twists and turns to the plot that most folks have lost track of it.

But for any investor who dabbles in the Indian bond market, this case is a good illustration of how Murphy’s Law can operate on one’s investments.

Retail investors who were unlucky enough to participate in any of the multiple tranches of DHFL NCDs (non-convertible debentures), have found that none of the regulatory safeguards that were supposed to protect their interests have worked as they should.

Mercurial ratings

 

To help retail investors navigate the minefield of debt investing, regulators place considerable faith on the opinions of rating agencies. SEBI’s (Issue and Listing of Debt Securities) Regulations make it mandatory for all NCD issuers to obtain credit ratings from at least one rating agency and to disclose this in their offer documents.

But investors who bet big money on DHFL bonds based on their top-notch credit ratings have had every reason to rue their decision. When DHFL issued its series of NCDs between 2015 and 2018, it enjoyed high investment grade credit ratings from not just one, but multiple rating agencies. Then, CARE and Brickworks rated its NCDs AAA, while CRISIL and ICRA rated its commercial paper issues A1+.

After the Cobrapost allegations, in February 2019, the rating agencies sought to hedge their bets by lowering the NCD ratings to AA+, but they remained high investment grade, with hopes pinned on asset monetisation. It was only in June 2019, after an actual instance of default by DHFL, that the rating agencies made bold to peg down its ratings to D (default grade). The DHFL case is not the first where rating agencies have scrambled to bolt the stable doors after the horses have bolted.

Given that rating agencies can change their minds on the creditworthiness of an issuer any time after investors buy its bonds, it appears rather futile to place so much emphasis on ratings at the time of the issue.

Uncertain collateral

While investing in bonds, investors are often advised to prefer secured NCDs over unsecured bonds or fixed deposits, as in the case of any default the underlying collateral can be liquidated to meet one’s dues. By this yardstick, most lenders to DHFL should have no reason to panic as ₹74,000 crore of its ₹84,000 crore debt, is from secured creditors.

But the case that Reliance Nippon AMC has been fighting against DHFL in Bombay High Court shows that, in India, the collateral backing your bonds can prove ephemeral too. The AMC had subscribed to multiple tranches of DHFL NCDs that were secured by a first charge on the company’s receivables.

But it found that, while repeatedly defaulting on its dues to secured NCD holders between May and October 2019, DHFL had continued to make selective payments to unsecured creditors.

The AMC also alleged that DHFL had ‘dealt with’ the collateral backing of its secured NCDs while inking new securitisation deals with banks. Now, whether repayments by home loan-takers on DHFL’s securitised portfolios can really qualify as collateral for NCDs is a contentious issue. After initially seeing merit in the AMC’s case and imposing a blanket freeze on DHFL repayments, the Bombay High Court has selectively relaxed it this week. Its final ruling is pending.

But the scramble for collateral goes to show that the floating charge that is used to market NCDs as ‘secure’ instruments in the Indian context, is far from fool-proof.

Lethargic trustee

Recognising that a dispersed bunch of bond-holders would find it difficult to hold big corporate borrowers to account, regulations place a heavy responsibility on debenture trustees to protect their interests. SEBI rules require every NCD issuer to appoint a qualified debenture trustee, who is tasked with calling for periodic updates from the borrower, supervising the creation and adequacy of securities and enforcing them in case of default.

But in DHFL’s case, Catalyst Trusteeship — the debenture trustee — seems to have been quite lethargic in the performance of its duties. It was only in June 2019, after DHFL had defaulted on a few obligations, that it disclosed the company’s failure to maintain adequate security for its NCDs of 2016-2018 vintage. DHFL had also skipped maintaining the 15 per cent Debenture Redemption Reserve required by the Companies Act from FY18. It was only after defaults surfaced that the trustee seems to have initiated legal action against DHFL for these slip-ups.

The trustee also proved less than forthcoming in its communications with bondholders. Writing to DHFL’s NCD holders for the first time in early August, it sought their written consent for an inter-creditor agreement and a draft resolution plan, offering rather sketchy details of what the plan entailed.

With quite a few retail investors either missing out on the communiqué or failing to grasp its import, just 24,400 of the 87,000 bondholders responded with their consent.

The details of this resolution plan, when they were finally made public in September, may have come as a shock to those who did respond. The plan proposed that NCD holders agree to defer their principal dues from DHFL for another ten years, with the company promising to use its future (uncertain) cash flows to repay their principal in instalments, with a modest ‘return on investment’ of 8.5 per cent.

Since then, an active skirmish has broken out between DHFL’s big lenders on this plan. While the banks seem keen to push ahead with it, institutional bondholders such as mutual funds appear to be resisting it on the grounds that the haircut is too steep. In October, Catalyst Trusteeship finally moved the Debt Recovery Tribunal on behalf of NCD holders.

But with a recent forensic audit by KPMG reportedly raising new red flags on DHFL’s loan book, an Enforcement Directorate investigation has kicked off, nipping hopes for a quick resolution in the bud.

Passive regulators

As this free-for-all has been playing out over the last nine months, both the National Housing Bank — the sector regulator for housing finance — and SEBI — the de facto regulator for bond markets — have been largely passive spectators, doing little to help retail investors caught in the cross-fire.

Had regulators ordered a third-party forensic audit on DHFL’s books immediately after the Cobrapost allegations, the problems may have come to light earlier, making for a more orderly resolution.

Had they intervened to ensure that DHFL and the debenture trustee kept retail investors informed as they engaged in hectic parleys with institutions, retail investors could have made more informed decisions instead of groping in the dark.

Overall, the DHFL case goes to show that the regulation and functioning of the Indian market for bond issues is today at the same rudimentary state that its IPO market used to be in the mid-1990s.

Until the conduct of bond market participants and the enforcement of regulations are brought up to scratch, small investors must perhaps be discouraged from directly subscribing to NCDs, through a high minimum ticket size and prominent disclaimers on the risk of capital losses.

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