The recent issues concerning debt funds arising out of credit issues have stunned the common investor who never thought he could lose money in a “safe" product such as a fixed maturity plan (FMP). Moreover, while a mutual fund does not guarantee a return in an FMP, every investor is aware of the approximate return that he can expect, a kind of a guarantee but not backed by any capital. An FMP product actually exists only due to its tax arbitrage over bank deposits. The FMP industry normally picks up when the interest rates are on an uptrend and the debt funds start showing lower returns. It’s time investors realise that a mutual fund is a pass-through product unlike a bank deposit where there is a guarantee on the back of capital.
A debt fund takes credit risk and if there is a default in the credit, it translates into a fall in the net asset value (NAV). But there have been very few cases when this has happened. However, this time the twin issues of the Essel Group promoter funding, and the ILFS Group default is going to test the industry. Most of the debentures that funds invest in are secured, but the security is not realisable immediately, unlike the structure where the debenture is backed with a liquid realisable security like an equity share.
Also, are funds equipped to take and manage credit risk like a bank where the banker actually sees the flow of funds into borrower bank accounts daily with regular reporting by the borrower? Increasingly, credit risk management is going to be a critical part of fund management. Now, where should credit risk be taken is the other question—in an open-ended fund or closed-end fund. To my mind, the closed-end structure is better for taking a credit risk as one holds the instrument to maturity and ensures that no investor leaves the fund. In an open-ended fund, savvy investors tracking the credit scenario could exit before the rest. Of course, when one invests in debt, there is credit risk; so lower credit could find its way into a credit FMP.
Perhaps, it’s time for the Securities and Exchange Board of India (Sebi) to consider putting in tighter regulatory controls:
1. Sebi caps the investment in equities at 10% of the net asset of the fund, while it is 12% for debt securities with a group investment capped at 20% of the scheme assets. So the tighter cap is not for an illiquid asset but for a liquid asset class. With a 20% cap at the group level, many of these FMPs have less than 10 securities in the portfolio, again defying the basics of a mutual fund, which is diversification. There is a case to cap corporate credit at 5% of net assets or lower; this would significantly reduce the risk and perhaps the timing is right as the Reserve Bank of India is now making it mandatory for corporates to access the bond markets as a proportion of their total bank borrowings. Of course, this will also reduce the spate of FMP launches due to the unavailability of sufficient credit assets in the near term.
2. Increasingly, investors will start looking at fund portfolios. Sebi should make it mandatory for funds to indicate the names of the promoters of all investee companies in the disclosure document. Further, fund houses manage debt fund redemptions at the fund level instead of scheme level. Due to this, there are a lot of inter-scheme transactions to manage liquidity. So an investor who does not like a particular instrument and invests in a fund after looking at its portfolio could see that instrument coming back into the scheme through an inter-scheme transaction that is undertaken at a later date. There is, therefore, a need to stop inter-scheme transactions or, at best, restrict them to 30-day securities that are amortised to maturity and manage liquidity at the scheme level. This should be done for equity schemes as well.
The above two suggestions, if implemented, will change the debt fund industry for the better.
Sandesh Kirkire is IMC Pravinchandra V Gandhi Chair, banking and finance, Jamnalal Bajaj Institute of Management Studies