Since the IL&FS crisis broke in September 2018, debt mutual funds have been buffeted by events that have at times caused their net asset values (NAVs) to half within a day. Such volatility has shaken investor confidence and reversed the shift from fixed deposits to debt funds. The Securities and Exchange Board of India (Sebi) came out with a raft of regulatory changes last week aimed at addressing many of these concerns.
Valuation norms altered, exit load introduced: Earlier, papers of up to 30-day maturity were valued using the amortisation method. Now, all papers will have to be valued on mark-to-market (MTM) basis. In the former method, the paper’s value rises steadily as it moves towards maturity. With MTM being introduced, NAVs of funds will reflect better the price their underlying papers can get in the market. However, NAVs of liquid funds could become slightly more volatile.
A graded exit load will apply to liquid funds for up to seven days. Its purpose is to nudge institutional investors to enter liquid funds for at least a week.
These investors, who account for the bulk of investments in liquid funds, tend to have a lumpy investment pattern. Towards the end of each quarter, they withdraw large amounts, then reinvest it after a few days.
When institutional investors exit, they do so at the fund’s NAV. In reality, the NAV is not truly reflective of prices at which bonds (the ones valued on amortisation basis) get sold in the market. Many sell for less. So, the institutional investor exits at a good price, while those who stay back take a hit. “With these changes, Sebi has ensured that investors don’t come into liquid funds for less than seven days, and when they exit those who stay behind do not suffer,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India.
Investors who wish to park their money for seven days or less should move to overnight funds. Those with a longer horizon should stick to liquid funds, which are likely to give higher returns than overnight funds.
Limits on investment in credit-enhanced bonds: A fund cannot have more than 10 per cent exposure to debt and money market instruments having credit enhancement. Exposure to such instruments from one group cannot exceed 5 per cent of the portfolio. Liquid and overnight funds will not be allowed to invest in structured obligations (SOs) or credit enhanced bonds at all.
Credit enhancement refers to mechanisms that allow the credit rating of an instrument to be improved. To give a simple example, suppose that a bond would have got a BBB rating and wants to improve it. If the total amount to be raised is Rs 1,000 crore, the promoter may offer a guarantee on the first Rs 100 crore. This allows the rating agency to give it a better rating. Such mechanisms allow weaker companies within a group to borrow at better interest rates. “Credit risk funds especially have high exposure to SOs and credit-enhanced bonds.
They will have to bring them down,” says Dwijendra Srivastava, chief investment officer-fixed income, Sundaram Mutual Fund.
Five percent of a Rs 100 crore fund is Rs 5 crore. Market lot sizes for these instruments tend to be Rs 25-50 crore. Smaller funds will hence find it difficult to invest in these instruments. According to Kunal Bajaj, head of wealth management, Mobikwik, “The message from Sebi is that funds should have lower exposure to complicated structures.”
Cover hiked on loan against shares: Sebi has taken two steps to deal with the issues arising from loan against share (LAS) kind of deals struck between mutual funds and promoters. One, the level of security cover has been hiked to four times. Two, Sebi has clearly defined “encumbered” shares. If there is any kind of restriction, direct or indirect, on the free and marketable title of a share, it will be regarded as encumbered. Promoters will have to disclose detailed reasons for encumbrance as soon as the level by promoters and persons acting in concert crosses 20 per cent of a company’s total share capital, or 50 per cent of their shareholding in the company.
In recent LAS agreements, most mutual funds had cover of up to 1.5 times. The promoter had pledged a large percentage of his shares to various lenders. When just a few lenders sold their pledged shares, the price fell dramatically. The value of the collateral became lower than the loan value.
The promoter could not offer additional shares as collateral as he had pledged heavily. “Now, unless the share price tanks 75 per cent, the lender will have adequate collateral,” says Belapurkar.
If a promoter has pledged a high percentage of his shares, that information will be in the public domain. Investors will be wary of entering into an LAS deal with him. With a lower level of pledging, fewer lenders will come to the market at the same time to invoke the pledge. These steps will ensure that any large-scale lending that takes place is backed by adequate enforceable collateral.
What these measures mean for you: According to experts, debt funds are likely to become more fairly valued in future. Liquid fund investors are likely to be less affected by large outflows, and should become safer for investors. “In future, liquid funds should be marketed on the basis of how safe they are, rather than how high a return they have fetched,” says Bajaj. Limits on investment in SOs and tightening of sectoral limits (see box) will improve the risk management framework of debt funds. On the flip side, returns from liquid funds may come down slightly due to the rule requiring 20 per cent exposure to highly liquid instruments.