It’s high time for the market regulator to redefine debt fund categories

Since the time the Securities and Exchange Board of India (Sebi) notified the mutual fund categories and rules in October 2017, the system has gone through a lot of empirical events. In light of the learning curve we have had, willy-nilly, it is high time we redefine the rules. This is an open letter to all the stakeholders, including Sebi.

Include credit rating

Credit rating is a criterion in only two debt fund categories—corporate bond and credit risk. In the corporate bond category, it is minimum 80% in securities rated AA+/AAA and in credit risk, it is at least 65% in securities rated AA and below. In other categories, it is at the discretion of the asset management company (AMC). It is good to give flexibility to the AMCs in portfolio construction and the purpose of this point is not to say AA- or A-rated bonds are default candidates.

However, consider two illustrations of the issue. One, the case of ultra short-term funds, having A- and AA-rated bonds in the portfolio. These funds are just next to liquid funds and are expected to be “liquid” and, in the Indian context, liquidity in bonds rated less than AAA is a question mark. Two, consider short duration funds running a portfolio predominantly comprising securities less than AA+. These funds mimic credit risk funds and defeat the purpose of having a separate credit risk category.

Include portfolio maturity

In quite a few categories like corporate bond, banking PSU and credit risk, the portfolio maturity is not defined. The fund management industry is disciplined in this respect; AMCs do not take any undue long duration calls in these categories.

Still, it is better to define it in case a fund manager gets motivated to become adventurous and takes a long duration call like in a government security (G-sec) or a dynamic bond fund.

Include security-wise maturity

In the fund management industry, there is a jargon “barbell”. It means running a part of the portfolio with long maturity, but managing the average portfolio maturity on the lower side, by investing a part in shorter maturity papers. The longer maturity end of the yield curve is more volatile, hence a barbell fund can be more volatile than other comparable funds.

The issue here is deeper, in the context of the average portfolio maturity or average Macaulay Duration. In an ultra short-term fund, we now learn that only 50% of the invested quantum will come back in one year, it will take five years to get back 100% of the money and one security is maturing after nine years. All this while the portfolio duration is supposedly in the range of three to six months.

There is something technical here: for computation of Macaulay Duration, for instruments that have the put and call options, the put-call date is considered, not the “door-to-door” maturity.

Another technicality is that for floating rate instruments, the interest rate reset period is considered. For example, for a five-year maturity floating rate bond benchmarked to one-year Treasury Bill yield, it is considered as one year. Sebi has to make life simple for us. Over and above average maturity, security-wise maturity should be defined. In liquid and money market categories, instrument-wise maturity is defined as 91 days and one year. In other categories, it is just the average.

have a category for maturity run-down

In fixed maturity plans (FMPs), it is defined that the maturity of any instrument in the portfolio cannot exceed the maturity of the FMP. Accordingly, the remaining maturity of the portfolio comes down every passing day.

Reducing portfolio maturity reduces volatility risk. Nothing stops an open-ended fund from running this strategy, but there is no category for this. Introducing this would lead to clarity. A certain number of funds may be allowed per AMC, say three or five, where the AMC can define the initial and target maturity.

Reduce categories, simplify nomenclature

Some categories like medium duration or long duration or floater are not really used.

What are low, short or medium durations may not be clear to lay investors. Calling it something like “six to 12 months” or “one to three years” funds would make it clearer. Definitions also can be made uniform. Instead of defining categories in terms or maturity somewhere and Macaulay Duration somewhere and duration somewhere, it may be kept uniform as maturity.

Joydeep Sen is founder, wiseinvestor.in