Will the RBI’s ₹50,000-crore liquidity window for mutual funds resolve the issue?

In a bid to restore confidence among investors and offer liquidity support to mutual funds, the RBI announced ₹50,000 crore of special liquidity facility for mutual funds on Monday. The move follows Franklin Templeton’s decision late last week to wind up six of its debt funds, owing to liquidity constraints faced by the fund house amid large redemptions and high exposure to low-rated illiquid debt securities.

With the Franklin move threatening to snowball into an industry-wide issue leading to massive redemptions from other debt funds, the RBI has sought to abate concerns with its special liquidity facility for mutual funds (SLF-MF).

Under the SLF-MF, the RBI will conduct repo operations of 90 days at the fixed repo rate of 4.4 per cent. Under SLF-MF, banks will have to deploy funds for meeting the liquidity requirements of MFs.

The question is, can the RBI’s liquidity measure do more than just allay fears? Can it address the looming credit risk amid the Covid crisis that can lead to a fall in funds’ NAVs and increase redemption pressures?

Good news first

A chunk of the assets that mutual funds hold (across all debt funds) currently is in high-rated bonds and government securities. As of March 2020, the mutual fund industry holds about 80 per cent of debt fund portfolio in AA+ and above-rated bonds and sovereign papers.

For now, there is ample liquidity for high quality bonds, particularly after the RBI’s targeted long-term repo (TLTRO 1.0) announced on March 27, where banks have to deploy these funds in investment grade (BBB-rated and above) bonds and classify them as held to maturity (no mark-to-market risk).

Aside from Franklin’s six debt funds that have been wound up and credit risk funds of various AMCs, there are only a few other debt funds (fixed maturity plans)that have high exposure to AA and below-rated bonds. Hence, a majority of the funds may not face liquidity issue for now.

But then this comfort could diminish if there are massive downgrades of bondsowing to the Covid-led economic slowdown. This and given the fact that banks have been highly risk averse to low quality debt (weak demand under TLRO 2.0), how much RBI’s special liquidity will actually help needs to be seen.

Will banks lend?

The RBI’s TLTRO 1.0 has seen good response so far with bid to cover ratio (amount of bids to notified amount) at 2-4.5 times. But the deployment of such TLTRO funds has largely been to bonds issued by public sector entities and large corporates, especially in primary issuances.

To ensure that funds flow into NBFCs and MFIs, too, the RBI announced TLTRO 2.0 on April 17, under which funds will have to be invested by banks in investment grade bonds of NBFCs, with at least 50 per cent towards small- and mid-sized NBFCs and MFIs. The first such auction saw very weak response (bids for only have the amount), indicating the reluctance on the part of banks to invest in smaller NBFCs and MFIs and those below AA rating (though within investment grade).

Going by the extent of banks’ aversion to risky segments, it would appear that even in the case of RBI’s recently announced SLF-MF, funding may be difficult for MFs with a higher exposure to low rated bonds.

Funds under ‘SLF-MF’ have to be used by banks for meeting the liquidity requirements of MFs by extending loans, and undertaking outright purchase of and/or repos against the collateral of investment grade debt papers held by MFs. Now here is the chink. Banks may not be too keen to fund low quality debt portfolio of MFs, which is where there is dearth of liquidity. Hence, for few fund houses with high exposure to AA and below-rated paper or credit risk schemes, liquidity could become an issue if there are continual redemptions.

As of March 2020, many credit risk funds have 60-90per cent exposure to AA and below-rated bonds. If there are unabated redemptions from these funds, then liquidity could become an issue, despite RBI’s special liquidity facility.

While a chunk of the mutual fund industry’s portfolio currently is in high rated papers (AA+ and above), a series of downgrades in the light of worsening economic slowdown, is a key risk. Sharp fall in NAVs (owing to downgrades) can again trigger redemptions, leading to liquidity issue for the mutual fund industry. The RBI may need to step in again to offer liquidity window for mutual funds.

According to ICRA’s recent release, the credit quality of India Inc already faced elevated pressures in FY20 owing to sluggish consumption and investment demand. The pressures were further intensified by the increasing vulnerabilities of the financial sector, specifically NBFCs. ICRA downgraded the ratings of 584 entities in FY20, reflecting a downgrade rate of 16 per cent, which was significantly higher than the past five-year average of 9 per cent.

The volume of debt downgraded by ICRA in FY20 touched a high of ₹7 trillion, dwarfing the debt volume of ₹3 trillion downgraded in the preceding fiscal. The credit quality can only worsen sharply going ahead amid the Covid-19 crisis.