IL&FS default impact on debt funds (2018)
The IL&FS default of September 2018 marked the most consequential single credit event in the Indian debt mutual fund market in the decade preceding the COVID-19 crisis. When Infrastructure Leasing and Financial Services Limited (IL&FS) and its subsidiaries began defaulting on short-term commercial paper and non-convertible debenture obligations in September 2018, mutual funds holding these instruments suffered immediate net asset value (NAV) write-downs, interbank and capital market credit flowed sharply away from non-banking financial companies (NBFCs), and the Securities and Exchange Board of India was compelled to introduce a suite of emergency and structural regulatory measures. The episode revealed deep weaknesses in credit risk assessment, concentration management, and valuation practices within Indian fixed-income mutual funds and accelerated reforms that reshaped the industry for years.
Background: IL&FS group structure and activities
Infrastructure Leasing and Financial Services Limited was incorporated in 1987 as a private-sector infrastructure finance and development company. Over three decades, IL&FS expanded into one of India’s largest conglomerates, with interests spanning toll roads, ports, power projects, water treatment, and urban infrastructure. Its parent holding company, IL&FS Limited, was owned by a consortium including Life Insurance Corporation of India (LIC, the largest shareholder with approximately 25 percent), State Bank of India, Abu Dhabi Investment Authority (ADIA), Central Bank of India, HDFC Bank, and other institutional investors.
By 2018, the IL&FS group comprised over 170 subsidiaries and associate entities. The holding company and its key financial subsidiary, IL&FS Financial Services (IFIN), had borrowed extensively through the commercial paper and debenture markets to on-lend to infrastructure project companies. This maturity transformation, borrowing short in the money markets and lending long to infrastructure projects, left the group exposed to rollover risk if short-term market confidence eroded.
Deteriorating project economics and leverage
From approximately 2014 onward, several large IL&FS infrastructure projects experienced cost overruns, construction delays, regulatory disputes, and traffic shortfalls that impaired their ability to service debt obligations to IL&FS group entities. The holding company and IFIN continued to service their market borrowings by rolling over maturing paper, effectively borrowing fresh commercial paper to repay maturing obligations. This created a fragile debt pyramid that was sustainable only as long as lender confidence held.
The IL&FS group’s consolidated debt load was approximately Rs 91,000 crore at the time of the crisis, a figure that emerged only after the government-appointed new board conducted forensic investigations in late 2018. The absence of consolidated financial disclosures of adequate granularity had prevented market participants from fully assessing the group’s leverage ratio.
The default: August–September 2018
The proximate trigger was a liquidity squeeze at IL&FS Financial Services. On 27 August 2018, IFIN failed to repay a short-term deposit to the Small Industries Development Bank of India (SIDBI). This was followed on 4 September 2018 by a default on commercial paper obligations totalling several hundred crore rupees. On 11 September 2018, IL&FS Transportation Networks (ITNL), the group’s road project subsidiary, also defaulted on commercial paper and debenture obligations.
The defaults were shocking to the market for two reasons. First, IL&FS paper had been rated AAA or AA+ by domestic credit rating agencies, ICRA, CARE, and India Ratings, in the months immediately preceding the defaults. The rating agencies downgraded IL&FS paper precipitously from AAA to junk within days of the default, raising fundamental questions about the quality of their surveillance and the adequacy of rating methodologies for complex conglomerate structures. Second, the LIC and SBI parentage of IL&FS had led many investors and fund managers to treat it as an implicit quasi-sovereign credit, an assumption that proved entirely unfounded.
Mutual fund impact
Direct NAV losses
Indian mutual funds had significant exposure to IL&FS commercial paper and non-convertible debentures across liquid funds, ultra-short funds, short-duration funds, and credit risk funds. Estimates of total mutual fund exposure to IL&FS group entities at the time of the default ranged from Rs 2,500 crore to Rs 3,500 crore across the industry, with certain schemes holding concentrated positions.
The overnight write-downs in NAV were severe. Schemes holding IL&FS IFIN or ITNL commercial paper that defaulted overnight saw per-unit NAVs fall by 3–6 percent in a single day, an extraordinary event for instruments categorised as short-duration or liquid that investors expected to be near risk-free. Investors who had treated liquid funds as cash equivalents suffered losses that eroded the principal protection narrative central to that product category.
AMCs that disclosed large IL&FS exposures included HDFC Mutual Fund, Axis Mutual Fund, Birla Sun Life (now Aditya Birla Sun Life), DSP Mutual Fund, Franklin Templeton, and several others. The precise individual scheme exposures were initially not publicly available, and SEBI subsequently mandated more granular portfolio disclosure to address this opacity.
Secondary market freeze for NBFC paper
Beyond direct IL&FS holdings, the default triggered a broader systemic effect. Market participants extended their distrust from IL&FS specifically to the NBFC sector generally. Mutual funds, banks, and insurance companies simultaneously became reluctant to buy or roll over commercial paper and short-term debentures issued by other NBFCs and housing finance companies, regardless of their financial condition. The secondary market for NBFC debt effectively froze.
The mutual fund industry was particularly significant in this dynamic because money market and short-duration debt funds had, by 2018, become the largest buyers of NBFC commercial paper, supplanting banks that faced regulatory constraints on such lending. When mutual funds faced redemption surges and could not roll over maturing NBFC paper, the liquidity crisis extended to otherwise solvent NBFCs that relied on the mutual fund channel for short-term borrowing.
Dewan Housing Finance Corporation (DHFL), Indiabulls Housing Finance, and other large housing finance companies experienced sharp spikes in their commercial paper yields and difficulty placing new issuances in the weeks following the IL&FS default. DHFL eventually defaulted on its own obligations in 2019, representing a second major credit event with its own separate impact on credit-risk funds.
Government intervention and NCLT proceedings
On 1 October 2018, the Government of India invoked powers under the Companies Act, 2013, to seek the National Company Law Tribunal’s (NCLT) approval for removal of the IL&FS board and installation of a government-nominated new board. The NCLT granted approval the same day. The new six-member board, chaired by Uday Kotak (then MD and CEO of Kotak Mahindra Bank), assumed control on 4 October 2018.
The new board undertook a comprehensive forensic review of IL&FS’s liabilities, assets, and subsidiary-level finances. The final verified debt figure of Rs 94,000 crore across the group was substantially higher than prior public disclosures. The government also provided emergency liquidity support through LIC and SBI to prevent a complete collapse of IL&FS operations that might have impaired large infrastructure projects serving public purposes.
An NCLT-supervised resolution framework was established under which IL&FS entities were classified into Green (solvent, able to service obligations), Amber (partially solvent), and Red (effectively insolvent) categories. Resolution proceedings under the Insolvency and Bankruptcy Code were initiated for Red-category entities. The process extended over multiple years, with partial recoveries for debenture-holders and commercial paper holders in insolvent entities being significantly below par.
SEBI regulatory response
Enhanced credit risk management norms
SEBI issued Circular No. SEBI/HO/IMD/DF4/CIR/P/2019/102 on 24 September 2019, the comprehensive revised norms for credit risk management in mutual funds. Key provisions included:
- Single-issuer limit tightening: The exposure of any scheme to debt instruments of a single issuer was capped at 10 percent of NAV (down from 15 percent for investment-grade issuers in practice), with stricter limits for lower-rated paper.
- Group-level limits: Aggregate exposure to all entities belonging to a single group was capped, preventing the build-up of conglomerate concentrations like that seen in IL&FS.
- Sector concentration limits: Mandatory limits on sector exposure were introduced for NBFC, housing finance, real estate, and other sectors to prevent systemic concentration.
Valuation policy overhaul
The IL&FS default exposed a critical weakness in valuation methodologies: mutual funds had been carrying certain instruments at cost or accrual value rather than using market-linked prices, masking true portfolio quality. SEBI and AMFI jointly revised valuation guidelines to mandate waterfall methodologies, market price where observable, evaluated price from approved valuation agencies where not traded, and discounted fundamental value as a last resort. The Association of Mutual Funds in India published standardised valuation guidelines that became effective progressively from 2018–2020.
Credit rating agency surveillance reforms
The precipitous downgrade of IL&FS paper from AAA to junk drew sharp regulatory scrutiny of credit rating agencies. SEBI issued several circulars requiring rating agencies to:
- Enhance surveillance frequency for large complex borrowers.
- Publicly disclose material deviations between rated entities’ actual financial metrics and the metrics assumed in rating rationale documents.
- Adopt standardised default definitions aligned with international practice.
- Eliminate conflicts of interest in rating analyst compensation tied to client retention.
SEBI also conducted enforcement proceedings against ICRA and CARE for their IL&FS rating surveillance failures.
Introduction of side-pocketing (December 2018)
One of the most operationally significant regulatory responses to the IL&FS default was SEBI’s circular of 28 December 2018 permitting mutual funds to create segregated portfolios, commonly called side pockets, for debt instruments that suffered credit events or credit downgrades below investment grade. The side-pocketing mechanism, which had been debated in the industry for years, was finally operationalised as a direct response to the valuation distortions caused by the IL&FS default. Side-pocketing allowed AMCs to ring-fence impaired assets, protecting continuing investors from dilution by redemption outflows, while giving all investors proportionate claims on recovery proceeds.
RBI liquidity measures
The Reserve Bank of India responded to the broader NBFC liquidity freeze with a series of measures. In October 2018, the RBI increased the single-borrower limit for bank lending to NBFCs from 10 percent to 15 percent of capital funds temporarily. The RBI also conducted Open Market Operations to inject liquidity into the banking system. In February 2019, the RBI clarified the partial credit guarantee scheme under which government-owned banks could purchase NBFC assets, reducing the mutual fund sector’s exposure to the NBFC funding squeeze.
Investor impact
Direct NAV losses from IL&FS exposures were absorbed by unitholders of affected schemes in proportion to their scheme holdings. The losses were not systemic across the full debt fund universe but were concentrated in schemes with above-average credit-risk mandates and those that had relied on the quasi-sovereign credit perception of IL&FS.
More broadly, the episode triggered a flight to quality within the debt mutual fund universe. Investors shifted redemptions away from credit risk funds and toward liquid funds and overnight funds holding only sovereign or top-rated instruments. SEBI data showed that credit risk fund AUM contracted from approximately Rs 89,000 crore in September 2018 to around Rs 48,000 crore by March 2019, a reduction of almost 50 percent in six months, as investors exited the category.
This repricing of credit risk in open-end vehicles set in motion the structural vulnerability in Franklin Templeton’s six credit-oriented schemes that eventually led to their winding-up in April 2020.
Longer-term significance
The IL&FS default was the proximate cause of the most sustained credit market disruption in Indian fixed income since the 1990s. Its effects extended over three years through the subsequent DHFL and Yes Bank events and into the COVID-19 crisis. Taken together, these episodes reshaped the Indian debt mutual fund industry: credit risk funds contracted dramatically in both AUM and number of schemes; liquidity risk management became a first-order regulatory and operational priority; and the implicit assumption that rated paper was safe collapsed, forcing genuinely active credit analysis to replace rating-reliance.
The crisis also contributed to a significant rebalancing of the debt fund investor base away from corporate and NBFC treasuries, which had accumulated large cash management positions in short-duration debt funds, and toward retail investors with longer time horizons and lower sensitivity to single-day NAV moves.
Key dates
| Date | Event |
|---|---|
| 27 August 2018 | IL&FS Financial Services defaults on SIDBI deposit |
| 4 September 2018 | IFIN defaults on commercial paper |
| 11 September 2018 | ITNL defaults on CP and NCD obligations |
| September 2018 | Rating agencies downgrade IL&FS from AAA to junk |
| 1 October 2018 | Government seeks NCLT intervention; new board installed 4 October |
| October–December 2018 | Mutual fund credit risk AUM contracts sharply |
| 28 December 2018 | SEBI issues side-pocketing circular |
| 2019 | SEBI issues revised credit risk and valuation norms |
| 2019–2022 | NCLT resolution proceedings for Red-category IL&FS entities |