As more debt funds lend money to corporates—and especially those that follow a credit opportunity strategy—what happens if a borrower or an underlying company defaults? In this context, you might have heard the term ‘haircut’. What is it?
In August 2015, two debt schemes of erstwhile JP Morgan Asset Management Co. Ltd sank sharply on the back of a downgrade in Amtek Auto’s credit rating. In February this year, the net asset values of four debt schemes of Taurus Asset Management Co. Ltd fell 7-12% in just one day when one of its underlying investments, Ballarpur Industries, got downgraded.
When companies fail to pay interest, fund houses start writing off part of the asset’s value, starting 180 days after the interest payment due date. The book value is written off, and not just the interest component, because the assumption is when companies default on interest, they may default on principal as well. Thus, the slow and progressive write offs begin. Six months after due date of interest, 10% of asset’s book is written off, 20% after 9 months, another 20% after 12 months, 25% after 15 months and then remaining 25% after 18 months. If there is default of principal payment, the credit rating of the instruments falls to ‘D’ and credit rating agencies write off 25% of the asset’s value and stop providing the daily price to fund houses. At this point, the fund house’s internal valuation norms take over.
