India is catching up with China in an unfortunate aspect, namely defaults of high investment grade (AA and above) bonds. The first AA category jump-to-default (JTD) happened in 2014, with the recent being the third such event. While the Securities and Exchange Board of India (Sebi) has adopted more stringent regulations for credit rating agencies (CRAs) one hopes that such JTD does not become the “new normal".

A well-regarded regulator such as Sebi builds high expectations about its regulatory prowess. It has always kept the interests of retail investors at the forefront of its mutual fund regulations. Over the last several years, it has focused on reining in fund expenses and fee to distributors. It has enforced rationalization of schemes of mutual funds, as well as alignment of fund objectives to the fund name. However, Sebi needs to now rethink risk management norms of fixed income mutual funds.

In at least two of the three JTD cases, investors in several mutual funds faced significant losses. The market may have overreacted to the news of actual or rumored defaults. Still, such instances expose a significant vulnerability in risk management of at least some funds, which needs to be addressed. Specific focus is needed not just on managing credit risk but also on managing liquidity risk.

Beyond ticking-the-box credit risk management: True, AAA and AA+ does not mean zero probability of default, and investors have been warned about returns being subject to market risk. However, a JTD from AAA/AA+ in a matter of weeks and for the third time in six years is worrisome. Mutual funds have a high dependence on CRAs for the rating. However, passing on the entire blame to CRAs may not address the issue.

Funds typically have an elaborate approach to creating an approved list of companies in whose debt they invest. These supposedly involve detailed discussions by the mutual funds investment committee, which usually consist of senior officials. Subsequently, analysts monitor the credit to the extent that a lot of mutual funds have their proprietary rating score-card.

In the recent case of JTD, more than half a dozen mutual funds failed to detect any credit deterioration. It raises questions about the institutional ability to evaluate credit. Rethinking is required on enhancing access of information such as commercial credit bureau to mutual funds, as well as consideration for introducing a data-intensive analytical decision support system for large credit.

Liquidity risk on back-burner: Day-to-day redemptions are met by a combination of net inflows, cash holdings and selling of high quality highly liquid papers such as collateralized borrowing and lending obligations (CBLO), short duration certificates of deposit and government securities. Typical daily redemptions amount to 1-2% of assets under management (AUM) of a scheme. However, in adverse events, a large scheme may see redemption of 10-15% of AUM and smaller fund houses may see redemption requests of 25% and above in a day. If a fund decides to sell highly liquid investments to the extent of 10-15%, it can handle high redemption pressure without selling its core high-yielding credit assets. However, the dilemma before the fund is that maintaining high liquidity will drive down overall fund returns. It may be recalled that the premium a non-convertible debenture pays over risk-free rate is not just the credit risk premium but also involves liquidity premium.

Funds thus try to arrange for liquidity by having lines of credit (LOC) from banks but these are often uncommitted. Funds do not have to pay commitment fees and thus save expenses. Banks need not honour these when there is a systemic crunch. In such instances, the Reserve Bank of India (RBI) has enabled liquidity windows to facilitate mutual fund redemption.

In certain cases, the retail schemes may be used to park illiquid bonds (whose prices are not discovered but ideally should have been marked down) from institutional schemes. In short, retail investors sometimes bail out smart money.

Disclosure as risk mitigant: If a regulator prescribes limits on liquidity positions or credit rating thresholds, risk management gets mixed up with compliance. Participants find ways to bypass this while remaining compliant. Sebi could consider improved and frequent disclosure of risks that the fund holds as a tool to control risk. For instance, mutual funds regularly update Sebi on breaches, either with respect to investment concentration risk or credit risk. Regular breaches or the number of breaches could be disclosed to investors; likewise, the proportion of AUM, which as per the fund’s internal rating, is higher/lower than CRA’s rating. Regarding liquidity risk, mutual funds could disclose to what extent their current liquidity position will enable them to handle the worst redemption pressure they have experienced. A higher level of disclosure will sensitize investors about the nature of risks the fund holds and will give them a better view of the risk than a catch-all “returns are subject to market risk". In a market where investors reward mutual funds with AUM mostly for returns, enhanced risk disclosures may create a discerning class of investors who are willing to forego returns for better managed risks. The time has come to trust the judgment of common retail investors and tone down competency expectations from institutional investors.

Deep Narayan Mukherjee is a financial services professional and visiting faculty at IIM Calcutta. Comments are welcome at theirview@livemint.com

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