The real estate sector has been in distress mode and might be close to tipping point
The buzz about default in the real estate sector has grown in pitch. There are at least three consequences to a default. One, since most developers use short-term funds to finance their long-term holdings, a default in the short-term market will increase the credit squeeze on borrowers. Two, developers may have to let prices drop to ensure that defaults do not increase, freezing their source of funding. Post default price corrections are usually steep. Three, default in short-term markets will snowball into insolvency, when prices correct sharply. Real estate and property have sailed into the distress mode, and are close to the tipping point.

Lose-lose situation
Enough has been written about liquid funds and the redemption pressures they came under in the last two weeks. Many of them have now reverted to investing in very short-term liquid markets like the CBLO (the market for repos). Some have gone to the extent of saying that they do not hold any CPs (commercial paper) on their portfolios. Liquid funds are expected to provide investors who have short-term surpluses access to short-term money markets. This enabled deploying every rupee for every day, and earning market interest on that deployment. A simple strategy of a portfolio that is well laddered across CBLO, CPs, and CDs has worked well for these funds in the last 10 years. The portfolios have had good quality paper and carried no market risks. The earnings were almost completely made up of accrued interest. The redemption rush forced the sale of good quality paper at discounted prices, creating the panic. Mutual funds dominate the CP market. If they choose to withdraw from these markets, several NBFCs who have no other source of funding will find no lenders. The return to conservatism for liquid funds is likely to be lose-lose for investors and issuers of paper.

Flight to safety
The redemption pressure on Fixed Maturity Plans (FMPs) has led to rethinking of its structure. The yield war in this space has led to many funds holding high-yield paper, and investors do not like to be exposed even remotely to such risks. From choosing the highest-yielding FMP until recently, investors have switched to the most conservative of the lot. Given the matched structure of FMPs, it is tough to generate liquidity if investors redeem before maturity, and such redemptions hurt those who choose to stay. FMPs are now considering listing, so the redemption transactions do not impact the capital they manage. FMPs are very low-margin products for AMCs, making about 0.05 per cent as fees, therefore volume matters.

Does rating make sense?
In this hour of having to establish their credibility and keep investors, debt funds have sought to be credit rated. Historically, most debt portfolios have not held low credit-quality paper. The worry is about liquidity, and mutual funds are not structured like banks, with a fixed rate deposit and equity capital. The asset portfolio is funded by unit capital, and therefore any change in asset values directly impacts the NAV. In good times, one would wonder whether it makes sense to ask for a rating of the debt fund, considering that most securities held in the portfolio is rated, and holding of unrated paper is capped by regulation. Add to that the fact that the portfolio can undergo changes as it is rebalanced. There is no debt issuance by a fund, to seek a rating, in the traditional sense. But these are different times, and establishing credibility of the portfolio as certified by an independent agency matters. One hopes that this does not become the norm, as it would then create a difference in perception, in the minds of investors. They remain unitholders, bearing the risk of the asset portfolio directly, and should not be lulled into thinking that buying a credit rated debt fund is like buying a debt instrument.

Unintended consequence
Last year, Sebi came down on mutual funds holding bank deposits. As credit was expanding and banks needed the funds, liquid and short-term funds were able to use bank deposits to get a good yield on the portfolio. Sebi?s argument was that bank deposits were not liquid, and banks were simply investing in mutual funds, which in turn made these deposits and paid out a tax-advantaged return. Mutual funds had to hold ?marketable? securities, and not deposits. The effect of this regulation was that mutual funds shifted overnight from making deposits to buying CDs. The same banks now issued ?securities? and mutual funds got the yield they needed. What was lost in this arrangement was liquidity, that has now come to haunt liquid funds. The good old bank deposits were usually made for 1-year, but had only a 7-day lock-in and came with a one day put and call option. The CDs were of 91 day maturity, and were illiquid after issuance. No prizes for guessing why there was a distress sale when redemption pressures increased. Well intended regulation, but unintended consequences.