DHFL default impact on credit-risk funds

The DHFL default and its impact on credit-risk mutual funds unfolded through 2019 and 2020 as Dewan Housing Finance Corporation Limited (DHFL), at its peak India’s third-largest private housing finance company, progressively ceased to service its market borrowings, ultimately triggering the first use of the Insolvency and Bankruptcy Code (IBC) against a financial services entity. For Indian credit-risk funds and other debt mutual fund schemes that held DHFL’s non-convertible debentures (NCDs) and commercial paper, the episode produced significant NAV write-downs, accelerated redemptions, and reinforced the market’s already-heightened post-IL&FS scepticism about the creditworthiness of non-bank lenders. The episode also produced SEBI’s first large-scale enforcement exercise around credit risk classification and side-pocket usage.

Background: DHFL’s rise and business model

Dewan Housing Finance Corporation was promoted by the Wadhawan family, Rajesh Kumar Wadhawan and his sons Kapil and Dheeraj Wadhawan, and was incorporated in 1984. DHFL positioned itself as a lender serving the affordable and lower-middle-income housing segment in Tier 2 and Tier 3 cities, a market underserved by mainstream banks and large housing finance companies such as HDFC. It financed its lending book primarily through public deposits, bank borrowings, and capital market instruments including NCDs and commercial paper distributed to mutual funds and insurance companies.

By March 2018, DHFL reported a loan book of approximately Rs 97,000 crore and was rated AA by CRISIL, ICRA, and CARE. Its bonds were widely held by credit risk funds, medium duration funds, and short-term income plans across the industry on the basis of these ratings.

Early warnings

In January 2019, investigative reporting by Cobrapost alleged a network of related-party transactions, shell company diversion of funds, and undisclosed connected lending by DHFL promoters. The allegations were specific, naming entities and amounts. DHFL denied the allegations, but the reports triggered a sharp fall in DHFL’s listed NCD prices and a surge in commercial paper redemption demands.

The market’s response to Cobrapost’s allegations coincided with the broader NBFC liquidity stress that had begun after the IL&FS default of September 2018 . DHFL found it increasingly difficult to roll over its short-term borrowings and began requesting rollover extensions from institutional lenders. In April 2019, DHFL missed scheduled interest payments on several NCD tranches, constituting its first technical payment default.

Progression of the default

May-June 2019: first missed payments

In May 2019, DHFL missed principal repayments on NCDs held by retail NCD investors, which triggered formal default declarations by rating agencies. CRISIL, ICRA, and CARE downgraded DHFL to D (default) within days of the May 2019 payment failure. For mutual fund schemes holding DHFL instruments, the downgrade to D required immediate full write-down of the investment to zero or near zero under SEBI’s valuation norms, resulting in overnight NAV drops in affected schemes.

The single-day NAV falls were severe. Schemes with large DHFL concentrations recorded NAV drops of 5 to 8 percent in a single session, an extraordinary event for instruments categorised as investment-grade bonds just weeks earlier. Investors who had placed funds in credit risk schemes anticipating modest yield enhancement over liquid funds instead experienced principal erosion.

AMC exposures

Total mutual fund exposure to DHFL at the time of default has been estimated at approximately Rs 6,000 to 7,500 crore across the industry. The AMCs with the largest absolute exposures included Franklin Templeton (with DHFL bonds held across multiple schemes including those later wound up in April 2020 ), DSP Mutual Fund, Aditya Birla Sun Life Mutual Fund, and UTI Mutual Fund among others.

Importantly, DHFL paper appeared across diverse scheme categories, not just credit risk funds but also medium duration funds, short-term income plans, and banking and PSU debt funds, because the AA rating had made it permissible across a wide range of mandates. This broad penetration amplified the industry-wide impact.

Side-pocketing activated

Following the DHFL downgrade to D in June 2019, multiple AMCs activated the side-pocketing mechanism that SEBI had introduced through its circular of 28 December 2018, motivated by the IL&FS experience . DHFL became the first significant test case for the newly operational side-pocket framework in Indian mutual funds.

Side-pocketing isolated the DHFL holdings into a segregated portfolio within each affected scheme. Unitholders received units of the main portfolio (continuing to trade at market-linked NAV) and units of the segregated portfolio (valued at the write-down level, with recovery proceeds to be distributed as and when recovered). This structure prevented a “first-mover advantage” under which early-redeeming investors could exit at unadjusted NAV, diluting remaining investors, and protected the ongoing scheme from distress created by the impaired DHFL segment.

IBC proceedings and resolution

First financial sector IBC insolvency

In November 2019, the Reserve Bank of India approached the National Company Law Tribunal to initiate insolvency proceedings against DHFL under the Insolvency and Bankruptcy Code, 2016. DHFL became the first financial sector entity to undergo IBC proceedings, as the Code had previously been applied primarily to manufacturing and infrastructure companies. The RBI’s intervention required a specific amendment to the IBC, Section 227, to bring financial service providers within the insolvency framework.

The Committee of Creditors (CoC) included banks, NCD holders, and other financial creditors. Mutual fund schemes with DHFL NCD holdings were represented in the CoC in proportion to their verified outstanding claims.

Resolution plan: Piramal Group acquisition

A competitive resolution process attracted several bidders. In November 2020, the NCLT approved a resolution plan submitted by Piramal Capital and Housing Finance Limited. The plan provided for Piramal to acquire DHFL’s housing finance operations, with a haircut for financial creditors.

NCD holders and commercial paper holders, the categories relevant to mutual fund schemes, received an aggregate settlement that implied a recovery of approximately 38 to 45 paise per rupee of principal outstanding, depending on the specific tranche and seniority. Actual receipts for mutual fund schemes were distributed over 2021 to 2022 as the NCLT resolution proceeded and distributions were made.

The recovery of 38 to 45 percent on defaulted DHFL paper, while significantly better than the zero recovery that had been anticipated in the immediate aftermath of the default, still represented material permanent capital losses for investors in affected schemes from which distributions had not been previously received.

Impact on credit-risk funds category

The DHFL default compounded the damage already inflicted by IL&FS and reinforced the trend of investors abandoning the credit risk fund category. SEBI data showed:

• Credit risk fund AUM contracted from approximately Rs 89,000 crore in August 2018 (pre-IL&FS) to approximately Rs 27,000 crore by December 2019, a reduction of nearly 70 percent in fifteen months.
• The number of credit risk fund schemes shrank as AMCs merged or wound down underperforming schemes rather than continue attracting fresh capital in a discredited category.
• Net flows into the credit risk fund category were negative in every month from September 2018 through 2021.

The sustained outflows from credit risk funds contributed directly to the stress in Franklin Templeton’s six schemes , which had concentrated in the same credit segment and faced a compounding liquidity spiral when investors sought redemptions that the illiquid portfolios could not immediately service.

Regulatory and legal consequences

SEBI enforcement: Karvy Stock Broking angle

The DHFL case had a peripheral intersection with the Karvy Stock Broking pledge-misuse investigation of 2019 . Forensic investigations of DHFL’s promoter-related transactions revealed irregular fund transfers that implicated several Wadhawan family entities. Criminal proceedings were initiated by the Central Bureau of Investigation and the Enforcement Directorate against Kapil and Dheeraj Wadhawan, with charges including criminal conspiracy, cheating, and money laundering.

RBI circular on financial sector IBC

The RBI issued a circular in November 2019, “Prudential Framework for Resolution of Stressed Assets”, establishing the regulatory framework for stressed NBFC resolution, motivated in part by the DHFL experience. This framework clarified the interaction between RBI’s supervisory jurisdiction over NBFCs and HFCs and the insolvency proceedings under the IBC.

Credit rating agency accountability

The rating agencies’ rapid downgrade of DHFL from AA to D, repeated from the IL&FS pattern, renewed SEBI’s scrutiny of rating agency practices. SEBI undertook a thematic review of the processes by which rating agencies monitored NBFC and HFC borrowers, subsequently issuing additional guidelines on enhanced financial covenants in rated instruments and mandatory disclosure of detailed financial projections underlying investment-grade ratings.

Lasting significance

The DHFL default, coming barely a year after IL&FS, consolidated a structural shift in Indian fixed-income mutual funds away from credit risk strategies. By 2021, credit risk funds had become a niche, low-AUM category, with the bulk of retail debt fund investment redirected toward liquid funds, overnight funds, and banking and PSU debt funds investing exclusively in sovereign or top-rated paper.

The DHFL IBC proceedings established important precedents for mutual fund participation in resolution processes, fund managers representing UH claims in Committee of Creditors discussions, and for the recovery treatment of different NCD tranches in financial sector insolvencies. These precedents have been applied in subsequent financial sector IBC cases.

The Wadhawan family promoters of DHFL were arrested, and criminal trials were under way as of 2023, representing one of the most significant accountability events in Indian financial sector history following a major borrower default.

Key dates

See also

• Mutual fund industry in India
• Securities and Exchange Board of India
• Reserve Bank of India
• IL&FS default impact on debt funds (2018)
• Franklin Templeton six-scheme winding-up (2020)
• Side-pocketing introduction (2018)
• Yes Bank AT1 bond writedown impact on mutual funds
• Karvy Stock Broking pledge-misuse case (2019)