Sebi likely to rejig mutual fund categorisation norms to curb credit risk

Restrictions on lower-rated papers may be put in place across most debt fund categories

The Securities and Exchange Board of India (Sebi) may rework the current categorisation norms to mitigate risk in medium- and shorter-tenure debt mutual funds (MFs) that take credit risks.

Currently, most debt fund categories do not have restrictions on the amount of credit risk they can take. Credit risk funds and corporate bond funds are the only categories that define credit exposure — for the former, 65 per cent of assets has to be in papers rated ‘AA’ or below and, for the latter, 80 per cent of assets has to be in the highest-rated papers. 

Ten out of the 16 debt categories are defined based on duration alone and the regulator might look to specify the amount of credit exposure that can be taken in these funds, said people in the know. For instance, a low-duration or ultra-short duration fund may be mandated to invest 65-75 per cent in the highest-rated papers. 

“Today, across categories, including the less-than-one-year bucket, there are funds with 65-70 per cent in ‘AA-’ and below-rated papers. This should not be the case,” said Dhaval Kapadia, director-portfolio specialist at Morningstar Investment Advisers India. 

According to Kapadia, these schemes should technically be classified as credit risk funds, but because each fund house is allowed to have only one credit risk fund, they are not. “Since the credit profile is defined for only two categories, fund houses have used it to their benefit.” 

In the past few months, the net asset values of several low-duration and medium-term funds have taken a hit as high as 5-10 per cent or more after sudden downgrades and defaults. Nearly three-fourths of the debt money as on May 31, 2019, was invested in securities with a duration of below three years. Sixty nine per cent was in securities with a duration below a year. 

On average, the ultra-short duration, low-duration, and short-duration categories had 26-28 per cent of their assets in ‘AA’-rated papers and below as of April 2019, with several schemes having a far higher exposure, the data from Morningstar India shows. The medium-duration category had, on average, more than 50 per cent invested in these papers.

“Any scheme duplicating the portfolio of a credit risk fund should be labelled as such. The regulator needs to step in to ensure investors do not take on higher risk without their knowledge,” said a debt fund manager. 

Market observers believe that the performance of shorter and medium duration funds varied, depending on the kind of credit risks they took. And the regulator defining credit profiles for these funds might level the playing field among fund managers. “The portfolio yield used to give away the kind of credit risk a fund house was taking. Setting credit limits for these funds will make their performance more comparable,” said another debt fund manager. 

On the flip side, guidelines to lower credit risk or improve liquidity will result in lower returns. This may reduce the attraction of the MF platform to investors looking for a higher yield, said experts. Also, setting new limits might not eliminate credit risk altogether, as even ‘AAA’-rated papers face the possibility of downgrades.

To avoid this situation, one fund house has asked the regulator to divide each category into two — one sub-category that is allowed to take credit risks and the other that sticks to ‘AAA’-rated and sovereign portfolio. Doing so, however, may result in a proliferation of sub-categories. 

Kapadia, for his part, believes that investors seeking higher returns should invest in the existing credit risk category rather than shorter duration or medium-tenure funds. The regulator could also look at allowing two or three credit risk funds per fund house (instead of one currently) that would invest based on differentiated strategies, he added.

Notably, corporates have already put in more checks and balances in place before committing monies to debt schemes. Many are asking fund houses to tweak their portfolios to include more ‘AAA’-rated companies and sovereign public sector undertakings, even if it means sacrificing returns. 

Sebi had introduced scheme categorisation guidelines in October 2017, with an aim to declutter the fund ecosystem and distinguish schemes based on asset allocation and investment strategy.