Thrilled that equity mutual funds were such a hit with retail investors, the Indian mutual fund industry was planning a big push to take its debt schemes to retail savers next.

But events over the last couple of weeks show just how complicated it would be to get the retail investor, so used to the predictable returns of bank deposits or post office schemes, to understand the strange workings of the Indian debt market.

As Cyclone IL&FS tore a destructive path through the bond markets in recent weeks, mutual funds were the first set of bond market players to feel its effects. As the credit ratings for IL&FS and its group entities fell steeply from investment to junk grade, debt mutual funds that held these bonds took immediate hits to their Net Asset Values (NAVs).

A decision by DSP Mutual Fund, which also had exposure to IL&FS paper, to sell its DHFL bonds at a discount set off an irrational panic about the NBFC sector. Preliminary reports suggest that this episode added to redemption pressures on debt funds which usually see outflows this month on advance tax pay-outs.

No cause for alarm

Unsettling as all this has been, gloom-and-doom reports about this episode causing a ‘collapse’ of the mutual fund industry are heavily overdone. Data from Value Research tell us that the aggregate mutual fund exposure to IL&FS debt was about ₹2,900 crore in end-August. This amounts to just 0.2 per cent of the ₹14-lakh crore assets managed by debt funds. It is only for the 11 debt schemes that own a significant 5-10 per cent exposure to IL&FS paper that the default will mean a significant setback to returns.

Yes, if the issue snowballs into a refinancing crisis for all NBFCs (which is unlikely), that would be a worry. But calm appears to be returning to the market after the Centre’s offer of liquidity support after superseding the IL&FS Board.

Weaknesses exposed

But this episode has served to highlight the many frailties in the workings of the domestic bond market. This is a reminder of the fallibility of rating agencies in assessing the credit-worthiness of borrowers. From a governance perspective, it’s a shocker on how big-name firms can hide skeletons in their closets.

It also goes to show how illiquid and shallow the Indian bond market can be, when confronted with even a single event of default. The fact that bond deals happen mostly through the private placements also makes them susceptible to misinformation. This opacity and lack of liquidity in bonds when you most need it doesn’t matter to most other players in the Indian market — be it banks, insurance companies or pension funds. They aren’t highly accountable to their investors and have their assets securely locked in.

But it does matter to the mutual fund industry, which discloses monthly portfolios and daily NAVs, follows mark-to-market accounting and promises swift redemption at the latest NAV in its open-end schemes.

That’s why the fund industry has a lot of housekeeping to do before it can aggressively sell open-end debt funds to naïve bank deposit investors.

More in-house research

Many sordid details of the IL&FS group’s financials have tumbled into the public domain after the default. They beg the question: Even if rating agencies messed up by ignoring the group’s precarious finances, why didn’t debt fund managers take note of them? Did they simply rely on the rating agencies for their credit assessment? Or did the high yields offered by IL&FS prompt them to disregard the risks?

We may never know the truth about IL&FS. But it is important for the mutual fund industry to introspect on these lines and fix the gaps in its credit appraisal processes before it actively promotes debt products to risk-averse retail investors. The fact that the IL&FS bonds figured in many liquid, ultra-short duration and short-duration funds, which are marketed as alternatives to bank deposits, makes it even more critical for MFs to improve their risk management skills.

Better communication

It is true that debt fund managers will sometimes get their calls wrong, just like equity managers do. But when things go wrong, it is important own up to mistakes and reach out to investors to reassure them.

Now, in the case of debt mutual funds, AMCs seem to have no well-thought out communication strategy to reach out to their investors in the event of sudden risks. In the panic following the IL&FS downgrades, some AMCs put out notes to distributors and investors, others gave quotes to the media, or clarified on their social media handles.

Unlike listed companies, most mutual funds in India do not have an ‘Investor Relations’ section on their home page that immediately directs the user to an important update. Therefore, lay investors looking for information are forced to trawl through tonnes of material before they get to the relevant note. While cryptic communication may be sufficient for corporate treasuries with a good grasp of bond markets, the fund industry will need to be far more proactive and elaborate with its communication to appeal to retail investors.

In fact, it would be beneficial if all AMCs are required to provide material event updates to their unitholders, just like listed companies, on a common platform like the AMFI or BSE websites.

Retail-institutional separation

Thanks to the lack of liquidity for lower-rated bonds, a big challenge that debt fund managers face when confronted with a sudden credit downgrade, is how to meet redemption demands. Selling the bonds that have been hit by downgrades can be nearly impossible. Therefore, they often end up liquidating their better-quality bonds which are easier to sell.

Now, this can create an unjust situation for the patient investors who stay with the fund. As the fund is forced to sell its family silver, it is left holding sub-par paper, rendering it both illiquid and risky for its remaining investors.

The lack of uniform valuation norms for corporate bonds and their sporadic liquidity, are issues that need to be taken up on a war footing if the open-end fund structure is to work smoothly for debt funds. SEBI floated a discussion paper in May on standardising corporate bond valuation and the industry must give it serious consideration.

Given its significant contribution to bond market development today, perhaps the MF industry can lobby the RBI for a special liquidity window for high quality corporate bonds, like the repo window for banks.

But the industry can certainly do its bit to make life easier for retail investors by not mixing and matching both retail and institutional investors in the same debt schemes. As smart institutions investors often get wind of trouble early and rush to redeem, it is retail investors who are left holding the baby.

The best solution to this problem would be for AMCs to create separate products for first-time retail investors testing out debt schemes. If these schemes can be managed with minimal credit and duration risks, and deliver less volatile returns, perhaps the aam aadmi would take less convincing that debt mutual funds are the sahi option.

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