Managing risk

Debt fund managers need better due diligence models

The Securities and Exchange Board of India’s (Sebi’s) decision to consider changing the guidelines for open-ended debt mutual funds could lead to some reassessment of the segment by investors. The regulator is considering asking all funds to hold a percentage of their portfolios in liquid assets. It may set up an expert committee to create a model for regular stress tests and assessment of the liquidity profiles of schemes. This could be backed up by additional transaction costs to be levied on illiquid portfolios. Better liquidity could ease the situation for funds faced with sudden redemption calls, and it may reassure investors who find it hard to assess the quality of debt portfolios. However, much of the woes of the debt fund segment arise from structural factors beyond the control of individual fund managers. The lack of a secondary bond market and the poor quality of assessments by rating agencies make it hard for managers to either lay off risks or even to assess risks systematically.

At this point, yields on government paper are running below inflation. This means the real return from debt is negative. In addition, vast and growing government borrowing has shouldered out corporate paper from the bond market. By definition, treasury debt is safe and liquid and many debt funds hold a healthy percentage of government debt, which means that liquidity should not be such a major issue. Forcing debt funds to hold a higher percentage of liquid assets will certainly draw down their returns. Hence, the fund industry will be reluctant to lock up more assets in a liquid portfolio. Another problem is that there is a great deal of uncertainty about the quality of corporate debt at the moment. The pandemic and associated lockdowns have meant that most companies are generating below-par revenues and, once the moratoriums cease, even top-rated firms could struggle with debt-servicing.

The experiences of the past few years, when top-rated companies and non-banking financial companies spiralled into sudden default, also show that the assessment of rating agencies can be highly flawed. India’s lack of a liquid secondary corporate bond market makes it hard, if not impossible, for debt funds to cash out corporate debt holdings, even at deep discounts. Developing better risk models is imperative for fund managers who will have to go beyond the ratings to do due diligence. A good, robust stress-testing model might help. But it may be noted that the Reserve Bank of India has been stress testing bank portfolios for many years, and its models have consistently under-estimated the baseline risks. Hence, it is likely that the purported Sebi stress testing model will take at least some time to produce accurate results.

All this means that the real risks for a debt fund investor and, by implication, the risks for managers of debt funds are much higher than what is apparent, going purely by ratings. Every player in the debt market is braced for unpleasant surprises at this point. The better fund houses will have to develop their own internal models for due diligence and risk assessment and those models will have to go well beyond the official ratings and the regulators’ stress tests. Policymakers would be well-advised to examine the root causes of bond market illiquidity and seek ways to improve the efficacy of rating agencies.