Sebi has set up a Working Group to assess the liquidity risk management of debt funds. The working group is understood to have been told to re-work liquidity norms for debt funds, especially open-ended ones, whose raison d’etre is, or should be, the right of investors to enter and exit at will
By N. R. Bhusnurmath
Debt mutual funds (MFs) have been in the news for a close to five years now. Sadly, for the wrong reasons! Problems first surfaced in 2015 when JP Morgan’s debt fund investments in Amtek Auto came a cropper, following the rating downgrade of once blue-chip auto ancillary manufacturer. And have come to a head now, following the suspension of six debt funds by Franklin Templeton MF in April this year.
With disillusionment in debt MFs becoming all-pervasive and the ripple effect of this threatening the fixed income market at large, capital markets regulator, Securities and Exchange Board of India (Sebi), has finally stepped into the breach. It has set up a Working Group to assess the liquidity risk management of debt funds. The working group is understood to have been told to re-work liquidity norms for debt funds, especially open-ended ones, whose raison d’etre is, or should be, the right of investors to enter and exit at will.
Apart from liquidity norms, ‘stress testing, gating of redemptions to prevent a run on the fund and a relook at side-pockets’ are, reportedly, some of the broad terms of reference. Sebi’s action is, presumably, driven by the desire to ensure open-ended schemes have enough liquidity buffer to withstand redemption pressures. It may be recalled that as part of this endeavour, Sebi has already allowed certain category of debt funds to invest an additional 15% in liquid assets to meet temporary COVID-19 related redemption stress in May 2020.
While this is all very well, the question Sebi needs to ask is the following: In its zeal to protect debt MFs, is the regulator over-stepping its role? Thus, though stress-testing, liquidity management norms, norms for side-pockets etc fall squarely within the mandate of the regulator, the regulator is on thin ice when it comes to the gating of redemptions. Even if the idea behind gating redemptions is to prevent a run on the fund, is it the regulator’s responsibility to prevent a run on a fund? Especially when this comes at the cost of preventing investors from exercising their basic right to exit at will from open-ended funds. Sure, investors might burn their fingers in the process. But that is an integral part of investing in capital markets. Remember, investments in MFs are subject to market risk; as the MF industry keeps telling investors!
To rewind to what happened in 2015. When the NAV (net asset value) of some JP Morgan debt funds fell dramatically following the Amtek default and investors began pulling out, the fund house initially suspended redemptions and then created a side pocket (a first for the MF industry in India) into which it corralled securities of Amtek Auto. Subsequently, JP Morgan was able to realise about 85 % of the value of its holding in Amtek Auto. But this was the first shock for debt MF investors, who had all along been lulled into viewing debt as a safer, if not fool-proof investment, compared to equity MFs. And more importantly, had taken for granted that exit-at-will is a basic right in the case of open-ended funds.
To digress a little, a ‘side pocket’ is an ingenious (?) tactic to segregate quality debt instruments in a debt portfolio from less kosher debt instruments that might have defaulted on interest or repayments or are faced with a rating downgrade because of deteriorating financials. After this is done, the fund’s NAV reflects the value of the good assets and a separate NAV is assigned to the side-pocketed assets based on their estimated realisable value. Once the doubtful assets are sold, the value is credited to unit holders continued with the MF at the time the side pocket was carved out.
The underlying rationale is that when there is news of a default or a ratings downgrade, investors in open end funds may panic and pull out money. Faced with a deluge of redemption requests, the fund house that holds illiquid downgraded securities might be forced to sell its quality holdings in a bid to meet the redemption pressure. At the same time, investors ignorant of these developments could be left holding the can thanks to severe erosion in the NAV of their holdings.
Something very similar happened following the collapse of IL&FS, where a number of debt funds that had exposure to bonds from IL&FS or its group entities had to treat their holdings as doubtful, and write it down fully, resulting in a cut of 6-8 per cent in their NAV, shaking investor confidence.
In 2015, when JP Morgan first sprang the side-pocket on unsuspecting investors, Sebi was slow to react. Subsequently, as more and more MFs took to side-pocketing (asset managers have reportedly created about 35 side-pockets for bond exposures to Yes Bank Ltd, Vodafone-Idea Ltd, Adilink Infra and Multitrading Pvt ltd, Altico Capital India Ltd, Dewan Housing Finance Ltd (DHFL), Zee etc), the regulator came out with guidelines in 2018. But clearly unease about the practice (and its ethics) continues. Hence the inclusion of side-pockets in the terms of reference of the Expert Group.
So, while there is no doubt Sebi needs to look into the working of debt MFs, it should, however, guard against being perceived as favouring the MF industry at the cost of investors. With luck, the Expert Group will give it the cover it needs.
(N. R. Bhusnurmath is Adjunct Professor of Finance & Banking at IMT Ghaziabad. The views expressed are the author’s own.)