Post the fallout of events in the debt space a year ago, the Securities and Exchange Board of India (Sebi) has taken several measures to streamline investment practices in debt funds. Sebi’s recent circular on the nature of instruments that debt funds can invest in has been made keeping investor protection in mind. But what is worrisome is whether some of these changes will lower returns from debt funds as a category in the long run. The broad strokes with which Sebi has chosen to implement some of these rules (specifically the cap on unlisted instruments and cap on structured obligations or SOs and credit enhancements or CEs) across all fund categories causes some concern.
Will this limit long-term returns?
Let us look at this from a long-term perspective. A debt investor’s long-term requirements are simple: she needs capital protection where possible, liquidity when needed, and returns higher than what fixed deposits (FDs) give for marginally higher risks. And remember that she needs all of this with limited volatility.
Steps such as side-pocketing provisions, uniform norms on valuation in the event of credit downgrades and caps on sector and group exposure are welcome measures of protection.
However, let us take the recent circular. It caps exposure of debt funds to unlisted instruments at 15% and then 10%. A review paper by the regulator on this states that this move will enhance disclosure and help develop the corporate bond market. This move, while improving disclosures for better credit assessment, is unlikely to directly benefit a debt fund investor’s need for liquidity. Listing does not guarantee liquidity. DHFL is a classic example of how a listed instrument can completely go bone dry on liquidity in tough times.
Besides, there are quality opportunities that may slip by for debt funds and instead benefit other institutional categories that are not subject to these rules. One can see that Sebi has arrived at these caps using the current median holdings of all debt funds. However, we believe that this yardstick has to be applied separately for different fund categories as each of them have different objectives, time frames and strategies. Categories that use accrual strategy, such as short duration, medium duration and credit risk, need a separate assessment as their return generation capacity stems from such opportunities that are being capped now.
Besides, while Sebi notes that such listing will develop the bond market, this restriction in mutual funds alone may not be sufficient as this law is not applicable for other institutional categories (such as insurance).
A fund manager’s ability to spot good quality credit early on gives her a good coupon. As the fund manager may be testing new grounds, clauses to protect the investment may be necessary in the form of SOs and CEs. Also, to expect the issuer of such an instrument to list such a security with a low borrowing base is not practical. By avoiding such categories, the opportunity to deliver returns to investors may be missed out.
Is duration the only way?
With all categories of funds being given uniform credit and listing requirements, there cannot be much distinction in their universe of opportunities. That means the distinction between fund categories and fund returns can come only through duration.
Unfortunately, duration comes with volatility. Over three-year time frames, duration-based funds such as dynamic bond funds delivered close to 8% on a rolling return basis. But almost three in every four funds have a history of negative returns over one-year time frames. In my experience with interacting with retail investors, they are willing to take such volatility in equity but not in debt. As a result, every time duration strategy shows some volatility, retail investors depart, with low returns or losses. Quality credit spaces like corporate bond funds are not any less volatile. Even in this present scenario, the three-year returns of medium duration funds (with over 40% in below AA+) are superior to that of corporate bond funds that boast of superior creditworthiness. Accrual is far less volatile, allowing investors to even generate regular income through systematic withdrawal plans.
An investor comes to MFs only because she cannot directly participate in many accrual opportunities in the bond market. The current grave situation in debt calls for tough actions but not ones that may start hurting once normalcy is restored.
Each debt fund category needs a separate assessment, to come up with norms that balance both safety and return potential. A one-size-fits-all approach can be limiting in the long term.
Adequate disclosure of risks in each fund, ensuring that categories don’t mask risks involved, and curbing mis-selling would address some of the concerns without curtailing opportunities that investors may want to participate in.
Vidya Bala is co-founder, Redwood Research