Investors expect mutual funds to be smart custodians of their money—selling weak companies early and reallocating capital to healthier opportunities. So when investors see bankrupt or near-defunct companies listed in a fund’s portfolio disclosure, it often sparks confusion and anger.
Why would a professional fund manager keep holding the stock or bond of a company that has already declared bankruptcy or defaulted? The answer is not simple negligence. It’s a mix of regulatory rules, accounting conventions, strategic calculations, and sometimes, reputational maneuvers.
This article explores why some mutual funds continue to hold bankrupt companies, the risks involved, and what investors can learn.
What “Bankrupt” Means for Mutual Funds
-
For Equity Holdings: Bankruptcy typically means the stock has collapsed in value, often trading in pennies. Yet it may still be listed.
-
For Debt Holdings: A corporate default means the bonds are no longer paying interest or principal. But recovery may still be possible through legal or restructuring processes.
In both cases, funds face a dilemma: immediately write off and sell for near-zero value, or hold on in the hope of recovery.
Reasons Funds Keep Holding Bankrupt Companies
1. Hope of Recovery Through Resolution
-
Under bankruptcy laws (such as India’s Insolvency and Bankruptcy Code, or US Chapter 11), creditors—including mutual funds holding debt—may recover a portion of their investment.
-
If a buyer acquires the distressed company or restructuring succeeds, bondholders may receive partial repayment.
-
Selling early at pennies may lock in bigger losses than waiting.
2. Illiquidity of Assets
-
Shares of bankrupt companies often have no buyers.
-
Bonds of defaulted firms trade at deep discounts, with very little liquidity. Funds may literally be unable to sell.
3. Regulatory and Accounting Requirements
-
SEBI and global regulators require funds to mark assets to market or to fair value. But unless a company is formally delisted or wound up, funds may still show holdings at token valuations (e.g., ₹0.10 per share).
-
Until the legal process ends, funds keep the asset in portfolios as “side-pocketed” or impaired holdings.
4. Avoiding Panic NAV Collapse
-
Writing off to zero instantly may trigger panic redemptions. By keeping bankrupt assets at a small assigned value, NAV declines are cushioned gradually.
5. Tax and Reporting Considerations
-
Loss recognition for tax purposes can be timed. Keeping the asset until legal resolution may allow funds to align accounting with recovery.
6. Reputational Strategy
-
Ironically, continuing to hold sometimes signals “we’re fighting for recovery” instead of admitting a complete write-off.
-
This can preserve some investor faith, even if it stretches reality.
Case Studies
1. IL&FS Default (2018, India)
-
Many debt mutual funds held IL&FS group bonds when the infrastructure giant defaulted.
-
Funds couldn’t liquidate; they side-pocketed these securities, hoping for recovery under bankruptcy resolution.
-
Investors eventually received partial repayments, years later.
2. DHFL Bonds (2019, India)
-
Debt funds heavily exposed to Dewan Housing Finance continued to hold its bonds after default.
-
NAVs fell sharply, but complete write-offs were avoided. Recovery through the Piramal Group’s acquisition brought back part of the value.
3. Lehman Brothers (2008, Global)
-
Many money-market funds worldwide held Lehman paper. When Lehman collapsed, funds “froze” the holdings. Some recovery came after liquidation proceedings, but investors faced delays and uncertainty.
4. Equity Examples: Jet Airways (India)
-
Equity mutual funds continued to list Jet Airways in their portfolios even after bankruptcy filings.
-
These were marked at token values, awaiting resolution bids.
Risks of Holding Bankrupt Companies
-
Illusion of Value
Investors see bankrupt firms in fund portfolios and assume recovery potential, when actual chances may be slim. -
Delayed NAV Impact
Instead of one sharp cut, NAV erosion drags over months, making losses less visible but no less real. -
Liquidity Freeze
Side-pocketed or impaired assets lock investor money until resolution, which can take years. -
Opportunity Cost
Capital tied up in bankrupt firms can’t be reallocated to better opportunities.
Why Funds Don’t Always Sell Immediately
Selling immediately at “fire-sale” prices means realizing near-total losses. For fund managers, waiting offers at least two possibilities:
-
Recovery via court-approved restructuring.
-
A buyer paying more than distress-sale prices.
From their perspective, holding is sometimes less about optimism and more about damage control.
SEBI’s Framework for Stressed Assets
After multiple defaults (IL&FS, DHFL, Franklin Templeton cases), SEBI introduced rules:
-
Side Pockets Allowed (2018): Funds can segregate distressed securities. Investors at the time of default retain rights to eventual recovery, while new investors are insulated.
-
Fair Valuation Guidelines: Independent agencies provide valuations for illiquid securities.
-
Disclosure Requirements: AMCs must clearly inform investors about impaired holdings.
This ensures transparency, but does not eliminate the fact that bankrupt firms may linger in portfolios for years.
Ethical Question
Is it ethical to keep showing bankrupt firms in portfolios instead of writing them off fully?
-
Pro: It preserves investor rights to potential recovery. Selling at zero when legal claims exist would be unfair.
-
Con: It can mislead retail investors, who may not understand that these holdings are effectively “dead money.”
The answer lies in clear disclosure. If AMCs educate investors about side pockets, risks, and recovery timelines, the ethical balance is maintained.
Lessons for Investors
-
Check Portfolio Disclosures Carefully
Look for “side-pocketed” or impaired securities. -
Understand Debt Fund Categories
-
Credit risk funds carry higher chances of exposure to bankrupt companies.
-
Safer options include liquid funds, government bond funds, and high-quality corporate bond funds.
-
-
Patience with Resolution
If your fund holds a bankrupt company, recovery may take years. Avoid panic exits that lock in full losses. -
Diversify
Don’t put all investments in one fund or one AMC. Spread across fund categories and managers.
Conclusion
When mutual funds keep holding bankrupt companies, it isn’t always incompetence—it’s a mix of legal necessity, recovery strategy, and sometimes cosmetic portfolio management. While such holdings can yield partial recovery down the road, they also expose investors to years of illiquidity, hidden costs, and trust erosion.
For regulators, the mandate is to tighten valuation and disclosure norms. For AMCs, the duty is to explain honestly why bankrupt companies remain in portfolios. And for investors, the lesson is caution: the mere presence of a company in a fund portfolio doesn’t mean it’s worth holding.
Because in mutual funds, sometimes the biggest risk isn’t what’s bought—it’s what refuses to be sold.
ALSO READ: AOL–Time Warner: the worst merger in stock market history
