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Business News/ Mutual Funds / News/  Sebi plans to reduce risks in debt funds

Sebi plans to reduce risks in debt funds

The markets regulator has come out with four proposals to introduce safeguards that may eventually help mitigate liquidity risk in these mutual funds
  • There are concerns that the rules may trigger the flight of institutional investors from debt funds
  • Sebi chairman Ajay Tyagi outlined the four proposals that can help improve liquidity in the corporate bond market (MINT_PRINT)Premium
    Sebi chairman Ajay Tyagi outlined the four proposals that can help improve liquidity in the corporate bond market (MINT_PRINT)

    The shock freezing of six debt schemes of Franklin Templeton Mutual Fund in April this year made a lot of investors wary of the debt market in general. The schemes were frozen as a result of a surge in redemptions in the schemes, which faced liquidity issues as they were unable to sell their holdings to meet the requests. Suddenly, investors became aware of the risk of lack of liquidity in debt mutual funds; the credit crisis had already shook their confidence in the last couple of years.

    In order to address this broad investor angst, capital markets regulator Securities and Exchange Board of India (Sebi) is now considering a set of proposals that have the potential to greatly reduce the risk in debt mutual funds and improve liquidity. The proposals, cumulatively, build safeguard against the recurrence of an FT-like episode. In a speech last week, Sebi chairman Ajay Tyagi outlined the four proposals that can help improve liquidity in the corporate bond market.

    We tell you what these four proposals are and what they mean for debt fund investors in India.

    Repos extended

    In a repo or lending operation, the borrower offers a security to take a loan. For example, a mutual fund with a portfolio of bonds worth 1,000 crore might need 50 crore in a week to meet redemptions. It can either raise the money by selling the bonds or borrowing against them. If liquidity is poor in the bond market, borrowing might be a cheaper option.

    While such repo operations are common when it comes to government bonds, that’s not true for corporate bonds.

    Tyagi announced that Sebi was considering setting up a central clearing corporation for repos in investment grade (BBB or higher) corporate bonds with guaranteed settlement. This can allow mutual funds to borrow money against their assets when redemptions are high without having to sell them at throwaway prices.

    “Repos in corporate bonds need two things to pick up. First, a standardized exchange-based system so that repo documentation doesn’t have to be repeated again and again. Second, a clearing corporation which will take custody of the collateral and guarantee trades. Even if the first is done, it can greatly improve liquidity in the corporate bond market," said Rajeev Radhakrishnan, head, fixed income, SBI Mutual Fund. Clearing corporations such as those which operate in stock exchanges guarantee that trades will be honoured. So, if the borrower defaults, the clearing corporation will sell off the collateral and make good the repayment.

    Creation of a backstop

    Tyagi outlined the possibility of creating a backstop mechanism, an entity which can buy illiquid debt during times of crisis. The corporate debt market is relatively illiquid even normally and a crisis aggravates this situation, making it difficult for fund managers to honour redemptions.

    However, the Sebi chairman did not outline how this entity would be funded.

    Minimum cash holding

    Current Sebi rules require liquid funds to hold at least 20% of their assets in cash (or equivalents such as treasury bills). However, there are no such rules for other debt fund categories. Sebi announced the constitution of a committee to look into the matter and said that interim rules will be framed until the committee gives its recommendations. The Mutual Fund Advisory Committee (MFAC) will be consulter in the matter, Sebi said.

    “Having all debt funds keeping some portion of portfolios in liquid papers like T-bills is a welcome step. This is something we already do in our debt schemes, apart from the liquid fund where it is mandated," said Radhakrisnan.

    However, a debt fund manager at a mid-sized fund house, who was didn’t want to be named, expressed apprehensions. “Asking debt funds to keep, say, 10-20% in cash can take a major toll on the returns. This is especially true for long-duration funds," he said.

    Swing pricing

    Swing pricing is a technique that imposes a cost on investors who make large redemptions from debt funds in times of crises. This affects the net asset value (NAV). “It is a concept applied internationally where large investors exiting or entering a fund get a price or NAV that more truly reflects the underlying debt portfolio transactions. It may be applied in India also, but it is only used in very extreme situations," said Radhakrishnan.

    The four proposals can go a long way towards making debt funds safer, when taken along with other Sebi measures such as putting limits on credit-enhanced securities. The issuers of these securities may not individually make the cut but get ratings due to enhancements like pledged shares in group companies or promoter guarantees.

    However, there are concerns about such policies triggering the flight of institutional investors from debt funds. “Cumulatively all these measures will push large treasuries away from debt funds for short-term needs. The stamp duty, for example, also has this effect. MFs will be more a place for HNI and retail investors, even debt MFs. Currently, almost 90% of the money in liquid funds and around 50% in other debt schemes is institutional money," said the fund manager, who declined to be named. This could affect the margins of AMCs due to lower volumes and, hence, increase the expense ratios of funds. On the plus side, schemes will be less vulnerable to the whims of institutional money.

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    Neil Borate
    I head the personal finance team at Mint. I have been writing about personal finance for the past 8 years after finishing two degrees in law and economics respectively. I do what I do, to help the ordinary Indian saver and investor.
    Catch all the Mutual Fund news and updates on Live Mint. Download The Mint News App to get Daily Market Updates & Live Business News.
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    Published: 27 Sep 2020, 09:26 PM IST
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