Managing the fault-lines in debt funds

The annual summit of AMFI, that is primarily intended to showcase the achievements of the mutual fund industry, has taken sudden, unpredictable turns over the last two years. SEBI Chairman Ajay Tyagi — glad to have mutual fund AMCs, distributors, analysts, media et al under one roof — has been giving everyone a piece of his mind about the problem areas in the mutual fund space, without mincing words.

He had the audience squirming in August 2018, when he blasted the reward structure for distributors and the advantage that larger AMCs enjoyed over the smaller players. What is more, the regulator matched his words with actions by issuing rules restraining distributor commissions and other rewards in October 2018.

The AMFI summit this year has gone along similar lines. The SEBI Chairman used the platform to chastise mutual funds for the excessive risk taken in debt mutual funds while chasing higher yields. He stated that the events in the debt market last year have exposed the fault-lines in the industry. The speech this year gives the indication that a new set of rules governing investments by debt mutual funds is on the anvil. However, while it is right to say that some fund houses have taken more risk than necessary, using regulatory gaps, and many industry-wide practices are not in investor interest, the numbers show that the situation is not too bad.

A closer look at the portfolio of debt mutual funds shows that the schemes have largely veered towards safer instruments. Funds amounting to ₹9,70,989 crore was parked in AAA, AA+ and A+ rated securities towards the end of July 2019. Another ₹1,68,165 crore was parked in sovereign debt, which is the safest option in debt securities. Of the ₹13 trillion plus in debt securities, 80 per cent is therefore in the safest investment category.

While debt securities with ratings of AA/AA-/A2, which fall in the riskier bucket, account for 9 per cent of debt assets of funds, A/A3 rated paper accounts for 5 per cent. Paper with BBB/BB/B rating accounts for only 1 per cent of debt mutual fund portfolios. Downgraded securities with ratings of ‘C’ and ‘D’ account for less than 1 per cent.

Also, as the SEBI chairman pointed out, the exposure to the stressed assets including IL&FS’ SPVs, ADAG group entities, DHFL, Cox and Kings, Essel Group and so on, amounted to only 1 per cent of the debt AUM. . In these assets too, not all are irredeemable. In some paper, while the repayment has been delayed, money is likely to be received by fund-houses in the future.

While the debt fund portfolios on the whole look alright, Tyagi is right in saying that risks have been exposed through recent events. While 22 mutual fund houses held the defaulting DHFL paper, investments made by DHFL Pramerica mutual fund in the securities were particularly large. Similarly, when Anil Ambani group entity Reliance Home Finance was unable to pay the amount due on the maturity of its NCD, many schemes in Reliance Mutual Fund, besides others, were seen holding the bonds.

With the portfolio disclosure of debt mutual funds not revealing the group that the borrower belongs to, it is very difficult for any investor to judge the amount of investments being made in the debt of entities in the same group.

Tyagi’s point that mutual fund trustees need to play a more active role as first-level gatekeepers is applicable in such cases. The regulator needs to spell out the guidelines for such investments to prevent fund houses from using investor funds to help related parties.

It also debatable whether fund houses need to take credit risk in short-duration, low-duration, ultra-short-duration, liquid funds, fixed maturity plans, etc. The regulation has not spelled out the kind of investments that these funds can invest in and only talks about the duration of the instruments. Fund houses are using the regulatory ambiguity to take higher risk across debt funds. Funds with smaller corpuses, facing massive redemption pressure, have been especially hit due to the higher risk they are carrying.

The other concerns raised in recent times is with regard to MF investment in debt and money market instruments having structured obligations with complex structures. Structured products issued with promoters’ shares as underlying have caused problems to some FMP investors of late.

Lending versus investment

The SEBI chairman’s remark about distinguishing between lending and investment by MFs is, however, debatable. With banks going slow on funding to corporates over the last few years, due to rising NPAs, mutual funds have emerged as a main source of financing for businesses.

Currently, most of the short-term funding requirement of companies is being met through mutual funds and insurance companies; working capital loans are mostly provided by banks. The long term requirements for businesses are also serviced by mutual funds and insurance companies through debentures, while term loans are provided by banks.

Also, with liquidity gushing into mutual funds since 2016, a lot of the excess funds have been lent to companies to meet their funding requirement. MFs seem to be taking their role as a lender rather seriously, accepting questionable collaterals such as promoters’ shares while lending to fund-strapped corporates.

That said, a balance needs to be struck in ensuring that companies are not deprived of funds in an attempt to restrain MFs from squandering investor monies.

Finally

As seen above, the scale of the problem facing debt MFs is not large. But much of the scare in recent times is due to the perception among investors that debt mutual funds carry no risk and are similar to bank fixed deposits. While investors are willing to face 80 per cent erosion in price of equity, they are intolerant with such erosion in debt.

Such misconceptions are largely due to mis-selling by intermediaries. The regulator as well as fund houses need to do more investor outreach programmes to clear this misconception; making it clear to investors that debt funds bring in some risk, because of which they are also able to deliver returns superior to bank deposits.

Several measures have been taken by the regulator in recent times to address issues in debt MFS, including permitting the creation of side-pockets, reducing the cap of overall sectoral limits, mandating minimum holding of 20 per cent in liquid instruments by liquid schemes, and so on.

While these changes are welcome, a one-time audit of all debt mutual funds might help restore confidence of investors about the holdings of MFs. Ultimately, it is up to the funds to remove riskier securities from their schemes and try sticking to the rule-book. This will lead to less ‘micro-managing’ by SEBI, as is commonly alleged.

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