Swing factor

Open-end debt mutual funds have gained traction with individual investors garnering ₹14 lakh crore in assets despite the obvious lack of depth and liquidity in the bond markets. The recent episode where scores of small investors were left high and dry by the sudden decision of Franklin Templeton India to wind up six of its debt schemes seems to have prompted the Securities Exchange Board of India (SEBI) to belatedly take up the 2018 report by IOSCO (International Organization of Securities Commissions) on the use of swing pricing.

Swing pricing allows a mutual fund to make adjustments to the Net Asset Value (NAV) at which investors buy or sell its units, so that when large investors stampede out, those left behind do not take undue hits from transaction costs or fire sales. It is widely used in the European, US, UK and Singapore markets. In its consultation paper though, SEBI proposes to take a slightly different tack compared to the developed markets. While these markets allow funds to optionally use swing pricing across market conditions, SEBI is proposing to start with mandatory swing pricing in times of market-wide dislocation. During times of crisis, SEBI will ‘declare’ market dislocation and require all open-end debt funds in high-risk categories to mandatorily use swing pricing. This appears a good move, given the bond market’s tendency to freeze up both on global risk-off events and local ones, such as the IL&FS default. SEBI has also suggested keeping redemptions of up to ₹2 lakh for all investors and ₹5 lakh for seniors out of swing pricing. Open-end debt funds will be allowed to have enabling provisions for swing pricing in normal times, provided they disclose their minimum thresholds and maximum swing factor upfront.

Given that debt funds are subject to high churn from corporate investors and own illiquid investments even in the best of times, a protection mechanism for retail investors from the flight of smart money is certainly much-needed. But as swing pricing effectively forces investors to bear higher costs for liquidity or investor concentration risks taken on by the fund manager, there’s a moral hazard to allowing the industry free use of this tool. To prevent misuse, SEBI must make sure that large investors do not get advance tip-offs on swing pricing from fund insiders. Liquidity costs are tough to quantify and vigilance may be needed to ensure that funds don’t excessively distort their NAVs under the guise of swing pricing. As retail investors often use debt funds to park emergency money, a higher threshold limit than ₹2 lakh may be needed during market dislocations. Finally, getting AMCs to run segregated debt portfolios for retail and institutional investors may better address many of the challenges associated with asset churn compared to the complexities of swing pricing.

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