OPEN APP
Home / Mutual Funds / News /  Opinion | Who is afraid of a junk bond mutual fund product?

The dust has settled for the moment on the question of whether retail investors should exit debt funds. The answer is no, they should not because in terms of flexibility and post-tax returns they do better than fixed deposits. But, both the regulator and mutual funds need to make changes that identify clearly risks investors may not know they carry. Debt funds are far more difficult to understand than equity, and unless the risk in these funds is clearly marked out, retail investors will hesitate to cross over from fixed deposits to debt funds. Debt funds are used more by firms than retail investors. Firms own two-thirds of the debt funds, while retail investors less than a tenth. Compare this with equity, where retail investors own almost half the assets. Corporate treasuries are constantly looking for that extra return from debt funds and choose those AMCs that bargain down costs and offer an extra return kicker. But higher return comes with higher risk.

Debt funds generate returns in several ways. One, when they buy bonds, there is the interest that the bond portfolio gives. Two, fund managers make judgment calls on the interest rate cycle and play on the ‘duration’ of the portfolio. In other words they seek higher return by playing around with the tenor of the bonds in the portfolio. Both these don’t really give a return kicker unless interest rates in the market suddenly fall or rise. It is the third return generator that gives the real kicker – the credit quality of the bond portfolio. We know that credit rating agencies give each bond a rating that shows how secure the bond is for giving a regular interest and the principal back. Corporate bonds with the highest confidence in their ability to service the interest and repayment of principal get the highest rating (triple A, for example). As the confidence in the ability of the bond issuer in servicing this debt falls, the credit ratings go down. As ratings go down, the issuer must promise a higher interest rate to the lender or investor. By buying lower credit paper mutual funds hope to generate a higher return due to the higher coupon and by punting on the rating going up in the future. But then the story gets complicated when a high-rated bond suddenly gets downgraded by the credit rating agency and the fund takes a hit on that part of the bond portfolio. A sudden downgrade leaves funds with more risk in their portfolios than they had promised investors. Funds can either take the loss on their own books, allow investors to feel the pinch of a market-linked product by reflecting the write down in the NAV or create a side-pocket to allow for the recovery process of the money from the firm. A side-pocket is an investor friendly solution that allows the fund house to move the distressed bond into a side pocket. As the fund is able to recover the money from the firm, the investors get a pro rata return even if they have exited. Side pockets were aimed at preventing contagion of one bad bond to the rest of the portfolio.

But risk has come from another quarter into debt funds. Mutual funds have been investing in debentures issued by promoters and promoter entities using shares as collateral. The promoters promise that if the value of the shares dip below a certain value; they would make good the difference in cash or more shares. If 1,000 crore of debentures are issued by firm A against its own shares that were valued at 1,500 crore, the deal is that if the share price falls below the formula of cover agreed upon (1.5 times or 2 times the value of the investment), the promoter will either post cash or more shares so that the formula value is preserved. Yes Bank was the first big case to hit the headlines when the value of the shares fell below the threshold value in November 2018. More recently when the shares of Essel Group companies like Zee Entertainment fell sharply to breach the collateral limit, there was pressure on the funds to sell shares to recover the notional loss. A consortium of fund managers and NBFCs worked out a deal with the promoter to hold off selling the shares for six months, giving the firm time to work through the sudden trough. This caused an uproar among analysts and commentators who called this deal unethical. The AMCs however say that they acted in investor interest and by not selling under pressure, they have actually done well by the investor. Zee Entertainment share prices bounced back from a sudden low of Rs318 to Rs486 in a month giving heft to the fund manager action. The jury is still out on whether the mutual funds were right or wrong in the eyes of the regulator, but such deals and arrangements are not unusual globally. Writes Texas law professor Henry Hu, in a Financial Times piece (on.ft.com/2Y8TEl2): “When creditors are faced with an overstretched borrower, they often choose to work with them. They may waive breaches of contract or agree to out of court restructurings because they ultimately want the debt repaid". There are also whispers of some corporate games being played to force mutual funds to sell by artificially squeezing the value of the shares. And there were other whispers of mutual fund investors’ money getting diverted to unlisted firms ahead of being siphoned off.

Whatever the back story, given the nature of the product, two interventions are needed to make this market safer for retail investors. Sebi needs to find a way to mark credit risk in every debt fund so that a retail investor can understand this risk and stay away if risk averse. Two, Sebi must allow a new category of funds called ‘junk bond mutual funds’ into the market. Junk bonds are those that fall outside the regulatory limits of investment-worthy bonds. When bonds slip from a high credit rating to junk bond status, the market freezes since there are no buyers. A junk bond mutual fund would provide that market. Higher return seeking investors can buy these funds knowing that they are in a product called junk bond XYZ mutual fund. By allowing such mutual funds that buy and sell junk bonds, and adequate labelling, an option to take higher risk will open up, as will an exit route for funds that are suddenly holding junk bonds in their otherwise investment grade portfolio. Market innovations happen after every crisis. Hopefully the debt fund crisis will be used to make the market better.

Monika Halan is Consulting Editor at Mint and writes on household finance, policy and regulation.

Catch all the Mutual Fund news and updates on Live Mint. Download The Mint News App to get Daily Market Updates & Live Business News.
More Less
Subscribe to Mint Newsletters
* Enter a valid email
* Thank you for subscribing to our newsletter.

Recommended For You

Trending Stocks

×
Get alerts on WhatsApp
Set Preferences My ReadsWatchlistFeedbackRedeem a Gift CardLogout