In a circular released on 1 October, the Securities and Exchange Board of India (Sebi) came out with wide-ranging norms for investment by debt mutual funds. The new regulations prescribe limits for investment in unlisted, unrated and credit enhanced securities, sponsor group exposure and sector exposure. Some fund managers, however, have highlighted that the requirement that debt MFs can invest only in listed commercial papers (CPs) is one of the key reforms that has emerged from this circular.
CPs are short-term debt issued by companies, typically for up to a year. So far, almost all CPs were unlisted, a fund manager told Mint, on the condition of anonymity. Listing forces issuers to make additional disclosures of their financial profiles. This norm will be implemented within a month after the framework for listing of CPs is operationalized or 1 January 2020, whichever is later.
Existing investment of debt funds in unlisted debt has been grandfathered (or allowed to be held) till maturity.
Though the circular said mutual funds may not invest in unlisted securities, including unlisted CPs, it carved out exceptions for government securities (G-secs) and those for whom a credit rating is not normally assigned like interest rate futures or swaps.
Sebi has also allowed funds to invest in unlisted non-convertible debentures (NCDs), provided they have a simple structure. Existing exposure to such NCDs needs to be brought down to 10% of the scheme’s portfolio by 30 June 2020. There was no such limit earlier. “One of the biggest takeaways from this circular is that mutual funds will not be able to invest in CPs that are unlisted. Over-exposure to CPs, both for the lenders and borrowers, was a major source for a number of issues in the recent debt crisis," said Mahendra Kumar Jajoo, head (fixed income), Mirae Asset Mutual Fund.
The circular also restricts exposure to unrated debt to just 5% of the net assets of a scheme. At present a 25% exposure to such securities is allowed. However, Devang Shah, deputy head, fixed income, Axis Mutual Fund, is more cautious. “The requirement for investment in listed CPs will enhance disclosures but this is more of an operational change. Many CP issuers were already issuing listed NCDs," he said.
Another major factor in the ongoing crisis has been credit enhanced securities (also called structured obligations). Several mutual funds had invested in this kind of debt issued by the Essel group which was backed by shares in Zee Entertainment Enterprises. However, attempts to sell pledged shares in January 2019 led to a sharp sell-off, forcing mutual funds to give borrowers more time to repay and enter into a “standstill agreement" not to sell the shares. Sebi has now stipulated that this type of exposure shall not exceed 10% of the scheme portfolio and exposure to a single group through this mechanism should not exceed 5% of the portfolio. The regulator has also stipulated a cover or collateral that is at least four times the value of the paper bought by the fund when there is lending against shares. “Since RBI allows two times cover for such lending by banks, Sebi has made the regime for mutual funds a lot more stringent," said a fund manager of a mid-sized AMC, on the condition of anonymity. “It is hard to see why any borrower would come to a mutual fund now for this type of lending when banks can offer easier terms," he added.
In terms of sector exposure, Sebi has brought down the limit from 25% to 20% and the additional limit for housing finance companies (HFCs) from 15% to 10%. In addition, the regulator also capped the exposure to a sponsor group to 10% of a scheme’s portfolio, which can be enhanced to 15% with approval from the board of trustees. Sebi has also mandated mutual funds to have a credit risk assessment policy and early warning system in place for deterioration in the credit risk profile of the issuer. “These guidelines will enhance risk management, help in diversifying portfolios and improve investor confidence in debt funds," said Arvind Chari, head, fixed income and alternatives, at Quantum Advisors Pvt. Ltd. “Returns on debt funds are always linked to market, liquidity and credit risks," he added, implying that lower risks may result in lower returns. “But given the episodes of the last one year, I believe that this trend towards flight to safety will continue for some more time, irrespective of these regulations," he said.
One major loophole that remains is exposure to non-sponsor groups which continues to be set at 25%. In addition, the circular is silent on “passive breaches". Such breaches occur when money flows rapidly out of debt funds forcing the fund to sell good papers to meet redemption demand. This, in turn, causes the share of downgraded or doubtful papers in the scheme to rise. Many schemes have provisions for remedying passive breaches in their scheme information documents (SIDs) such as a month-long remedy time-frame, said a debt fund manager, on the condition of anonymity. “However there is no regulatory requirement on this," he added.
“With the new measures, Sebi wants AMCs to be more proactive and objective in assessing the creditworthiness of issuers and reduce dependency on credit rating agencies where we have seen instruments getting downgraded from the highest to lowest rating within a span of few days," said Feroze Azeez, deputy CEO, Anand Rathi Wealth Advisors Ltd. He also highlighted the transparency brought about by disclosing details of debt instruments having structured obligations or credit enhancement in monthly portfolios.
The Sebi circular brings about some much needed tightening of investment norms for debt funds, although some issues remain unaddressed.