Neck deep

With over ₹8 lakh crore in their coffers, debt mutual funds have emerged as prolific lenders to corporate India, offering strong competition to banks and NBFCs. It is, therefore, unrealistic to expect the fund industry to remain immune to corporate India’s leverage problems, which have dealt such a severe blow to banks. The recent controversy about JP Morgan India Asset Management Company (AMC) exposes gaps in the governance structure of debt mutual funds that need to be plugged.

To start with, it isn’t clear why the two JP Morgan debt schemes chose to take exposures as high as 15.3 per cent and 5.3 per cent to the debentures of Amtek Auto, certainly not a top-notch borrower. Had the exposures been lower, the sudden downgrade in credit ratings would not have dented the fund’s NAV, forcing it to gate redemptions. SEBI regulations do allow debt schemes, with the approval of their trustees, to invest up to 20 per cent in individual bonds. But in practice, few schemes, especially short-term ones, take such high exposures to risky bonds. Even corporate bond funds, which by mandate take on credit risk, diversify by capping their holdings at 4 to 5 per cent. Therefore, a probe by SEBI into the risk control systems and the role of the trustees at JP Morgan AMC is warranted. SEBI should also consider tightening its 20 per cent exposure limit for bonds to say, 10 per cent. It can mandate the orderly winding up of a debt fund if it is in breach of prudential limits. Given the lack of liquidity and depth in the bond markets, almost every debt fund that invests in corporate bonds can subject its investors to disproportionate losses if it faces a redemption rush. While retail investors in debt funds cannot be shielded from market risks, SEBI should ensure that they come in with a full understanding of the risks. With bank deposit rates falling, there has been a tendency to mis-sell credit funds as ‘high-yield’ or ‘accrual’ funds to income-seeking retail investors.

There’s a clamour for SEBI to force the sponsor of JP Morgan AMC to buy out the affected bonds from its schemes. Though fund sponsors have resorted to such bailouts in the past, it cannot be a norm for the industry. For one, such bailouts pose a moral hazard problem, prompting both fund managers and investors to underestimate portfolio risks. For another, the fundamental difference between a mutual fund and a bank is that the AMC maintains no capital base of its own, manages money for a fee; as a pass-through entity, it transmits all profits and losses to investors. It has taken many years to convince retail investors of the virtues of this market-linked structure. Blurring the lines between banks and mutual funds will not do the financial system any good at this juncture.

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