There was a time when fixed maturity plans (FMPs) were corporate India’s favourite debt investment. But new regulations have taken liquidity out of the picture, putting their future in doubt. Since October, FMPs have lost Rs65,000 crore—almost half their assets.
Photoimaging: Raajan / Mint
Two major regulatory changes have affected FMPs. First, market regulator Securities and Exchange Board of India (Sebi) has forbidden redemptions at net asset value (NAV) by new closed-end funds, instead mandating that these funds be listed on a stock exchange as a way of providing exit. The practice of announcing “indicative” yields and portfolios has also been disallowed. While the indicative yield rule isn’t a major dampener, the lack of NAV-based liquidation is a big issue. The listing is unlikely to result in any meaningful markets for FMP units. In any case, the whole point of FMPs was that they were predictable.
Is liquidity important? In the current climate, it is. Investors don’t want to get locked into an investment without any recourse. The result is there for all to see. Since the new rules came out, there have been no successful FMP launches.
It won’t be surprising if FMPs die out eventually. The old ones will be redeemed and no new ones will be launched. That would be a pity. Except for the liquidity problem, FMPs have many desirable characteristics. It’s also possible that as the economic situation settles down, liquidity shortcomings will seem to matter less and shorter-duration FMPs will make a comeback as a viable investment.
Liquid funds reined in
With both investors as well as fund managers forgetting risk, liquid funds were rapidly increasing maturity and chasing returns. Now, Sebi has put a tight upper limit on maturity. Liquid funds will have commoditized, near-identical but safe returns.
Such funds, along with being ultra-safe, are ultra-conservative. They are not really meant to be investments—just a way of earning a few points of returns on short-term cash that would otherwise lie idle in bank accounts. However, in the euphoric and risk-loving mood that everyone was in till a few months ago, asset management companies (AMCs) were vying for liquid-fund investments by touting superior returns.
The result was that while liquid funds gave better returns, they were taking higher risks as well. During 2008, the average return of the category was 8.3%. Some even gave returns in excess of 9%. It is highly unlikely that such returns could have been generated by sticking to safe, ultra short-term investments.
However, when there was a crisis, investors started redeeming their investments and many funds were in trouble. The kind of investments they had were neither particularly liquid nor were they of the correct maturity. Sebi reacted strongly to this. On 19 January, liquid funds were ordered to reduce their maximum maturity to six months by 1 February and to three months by 1 May. Remember, these are maximum maturities, not the average ones that are quoted for debt funds.
With the maximum maturities reined in, fund managers will not find room to generate extra returns in liquid funds. Nor should they. The new regulations will return liquid funds to their proper roles as parking slots for short-term cash.
Renaming Liquid Plus funds
The story of Liquid Plus funds is a great example of the circuitous way in which the debt fund category has evolved. These funds were invented to avoid the higher dividend distribution tax that had to be paid on liquid funds. While that was the original idea, many Liquid Plus funds had no particular leaning towards high liquidity, at least not enough to justify the word liquid in their names.
It seems that during the credit crisis, many investors discovered that the word ‘liquid’ in Liquid Plus funds had no binding meaning. While Sebi has taken care of this particular problem, the naming and categorization of debt funds remains hard to understand even for many professional investors. In theory, there are more than a dozen different categories. In practice, the official objectives of most funds are written in such a way that a fund’s portfolio can easily shift across five or six different categories without any violation.
This is not a great basis for choosing a debt fund. While chief financial officers and other professional investors may be able to keep track of things, many investors are confused. Having a classifying system that helps them choose a fund would be better than having one which facilitates selling any fund to any investor.
With FMPs dying and liquid funds set to be commoditized, it looks as if things are going to be difficult for debt funds. However, there are many positives on the horizon.
Fundamentally, debt funds are simple products, or at least they ought to be. Unlike the complex world of equity analysis, all debt instruments can be reduced to five simple characteristics. Even better, all five of these are easily reducible to unambiguous numbers.
Take a look at the five pillars of debt investments—credit quality, returns, maturity, liquidity and tax. That’s all there is to it. Moreover, it is also easy for investors to map their own expectations and requirements on the basis of these five parameters. What looks like a complex market can be reduced to fairly straightforward criteria for choosing a fund. As long as an investor can define his own needs, it should be a simple matter to choose the debt fund that is the best fit for his needs.
Pillars of debt instruments
1. Credit Quality
Unlike equity, debt investments defined by five simple characteristics. As long as investors measure these for investments and match them to their own needs, debt investments can be simple, easy and safe.
Now that the negative fallout of the great liquidity crisis is over, there are many positives. The best side effect is fear of excessive risk, unexpected losses and of being trapped in a bad investment.
This fear is actually good because it reminds us why we are investing in debt to begin with. Why not go and invest in equity every time we have some spare cash for a few days? Because we don’t want the risk of loss. Because the first principle of a debt investor is preservation of capital. A debt investor may be willing to compromise on return, but not on safety. For safety to be maintained, selecting the correct type of investment is the single most important task.
The returns may be lower than earlier, but that will now be true of many categories because of a more risk-aware way of portfolio selection. In this new climate of safety and risk-awareness, both fund managers and investors will have to go back to the basics. And that’s not a bad outcome for something that started out as a really serious crisis.
There is no clear and uniform way of valuing debt securities in India.The same security could be valued differently in different funds’ portfolios at the same time if it is illiquid, thinly-traded and doesn’t have a market price. There is urgent need for uniform valuation that is public and transparent. Also, it’s not just the value but even the identity of debt securities that is often ambiguous. Although funds are mandated to reveal their portfolios, the lack of clarity makes such revelations meaningless.
Unlike equity, where there can be no ambiguity in what stock is mentioned in a portfolio, most debt securities in India do not have an unambiguous identifying number or code. Moreover, while each company issues only one type of equity in India, it may have issued dozens of debt securities. Some financial companies have hundreds of distinct securities that each have their own characteristics.
Some securities (basically those traded on the NSE’s debt market) have an Isin (International Securities Identification Number) code. But all of them don’t. In any case, funds do not list securities by Isin in their portfolio revelations.
The lack of a clear identity of securities makes Indian debt fund portfolio revelations a statutory obligation that do not help investors and analysts in any meaningful way. Unless the securities in a portfolio can be identified, not just the spirit, but even the letter of the law is being violated. Sebi would serve investor interests by clarifying that all securities must have an Isin number and this must be part of the portfolio revelation.
After FMPs, fund houses are now having difficulties launching interval funds. In the first two months of 2009, eight open-ended interval schemes were forced to close as they could not fulfil the mandatory provision laid down by the Securities and Exchange Board of India (Sebi).
Sebi regulations require all funds to have a minimum of 20 investors, with no single investor accounting for more than 25% of the corpus of a scheme/plan. These schemes, at the end of the last specified transaction period, were not able to meet these requirements. Consequently, they had to wind up.
In February, the mutual fund industry’s assets under management (AUM) rose by 8.86% and stood at Rs5.01 trillion, as against Rs4.6 trillion at the end of January. This was the third consecutive month when an increase in AUM was reported. Since December, the industry’s assets have risen by 19% . Reliance Mutual Fund was at the top once again. The AMC boasts the highest AUM, worth Rs81,627.08 crore. HDFC Mutual Fund and ICICI Mutual Fund were at the second and third spot, respectively. The former manages assets worth Rs56,864 crore while the latter’s are worth Rs53,538 crore.
Since the start of the year, 18 mutual funds have filed offer documents with Sebi. Out of these, 10 are debt-oriented. Some of these new products are interesting. The Tata PSU Bond Fund, for instance, proposes to invest primarily in debt instruments issued by domestic PSUs. Tata Triple Ace Fund, on the other hand, will focus on the credit rating of instruments in which it will invest.
The third offering by DBS Chola Mutual Fund offers two different investment plans under the same scheme —Flexi Debt and Regular Debt. Both plans have distinct asset allocation and will maintain different portfolios.
In the category of short-term gilt funds, only HSBC had recorded a negative one-year return as of 28 February. While other funds returned 7.39% on an average in the past year, this fund shed 4.25%. This dismal return stems from its unimpressive performance recently. The fund’s three-star rating in November and December fell to one star in January-February. A new fund manager and his wrong calls led to the poor performance. The fund had kept away from gilts since July 2004 and was into call money transactions only till December.
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