We just saw a brief display of what it could entail…
When DSP Mutual Fund sold DHFL bonds on Wednesday at a yield of 11%, it represented one of the steepest discount sales in recent memory and the impact was obvious. Fearing payment troubles at DHFL, the stock was hammered by over 50% on Friday and the shareholder wealth loss was over Rs.8000 crore. The total bond sale was just worth Rs.300 crore. Welcome to the world of IL&FS contagion.
What is IL&FS contagion?
That IL&FS is on the brink of a major default is, by now, well known and adequately documented. Consider the numbers. IL&FS has already defaulted on five of its obligations since August. The real problems are with IL&FS Transportation, where the money is locked in nearly 28 illiquid road assets. The company has only managed to repay around $68 million of its debt dues till date and has around $2 billion coming up in October. The rating agencies have already reduced the rating status of IL&FS paper to Junk indicating high risk of default. And the debt is not small. IL&FS almost operates like a shadow bank with debt to the tune of $12 billion. Unless some of the shareholders like LIC and other PSU banks chip in with liquidity, there is no way IL&FS will be able to meet any of these commitments. Remember, these are sticky assets and cannot be offloaded at short notice, despite the best of intentions.
Back to the DSP MF story
What DSP MF did last week was purely a pre-emptive measure to hedge its risks in the event of a string of rating downgrades. To begin with, it indicates that more NBFCs with exposures to IL&FS may see rating downgrades if there is no action taken on time. LIC has its own challenges in the form of a huge shortfall in Jeevan Saral that is coming up for maturity and that could limit the leeway for LIC. The DSP deal was significant because it indicated that mutual funds are willing to pare their positions even at a discount in NBFC paper. The 11% yield indicated an 18% discount; meaning an Rs.100 bond was sold in the market at Rs.82. If more funds opt for that route, then the contagion could truly spread.
How contagion spreads
Those who believe that IL&FS at $12 billion is small, think again. Contagion spreads fast. Say, IL&FS defaults again and a debt fund needs cash. G-Secs are in losses due to higher yields. An easier way out will be to sell other corporate bonds. The target will obviously be financial companies, mid caps and others where the vulnerability is of the highest order. And when such paper is dumped in the market at a steep discount, that is when losses spread and the contagion is obvious. The government needs to act really fast to prevent such a situation!