Mumbai: The markets regulator on Thursday tightened investment norms for liquid mutual funds to protect investors from credit risks arising out of defaults by borrowers.

The Securities and Exchange Board of India (Sebi) said liquid funds can invest a maximum of 20% of their assets in a single sector as against the current cap of 25%, and must keep aside at least a fifth of their assets in cash equivalents to meet sudden redemption pressures. Liquid funds are debt mutual funds that can invest in securities up to a maturity of 91 days.

“Mutual funds investment is different from bank lending and it needs to have elements of safety as well as investment," Sebi chairman Ajay Tyagi told reporters after a meeting of the regulator’s board.

The changes are based on recommendations made by the mutual fund advisory committee constituted by Sebi to limit liquid fund exposure to a single sector, especially to non-banking finance companies (NBFCs) catering to the housing sector. Mint had reported on 21 June that Sebi was reworking the sectoral caps based on the recommendation of the panel.

As a liquidity crisis engulfed India’s shadow banking industry following payment defaults by Infrastructure Leasing and Financial Services Ltd, mutual funds that had lent heavily to the non-bank lenders raced to cut their exposure. Questions have been raised about the safety of 13.24 trillion of assets under management (AUM) of debt funds. Mutual funds continue to have a massive 3.12 trillion exposure to NBFCs and housing finance companies.

Sebi’s latest changes will have a significant impact on India’s 25.93 trillion mutual fund industry, which has to comply with the new sectoral caps from September 2020.

Sebi has also reduced liquid funds’ exposure to the so-called credit-enhanced securities to 10% of AUM. A credit enhancement is typically a promoter guarantee or the offer of shares as collateral in order to enhance the creditworthiness of specific debt paper. These are also referred to as loan against shares (LAS).

The mutual fund industry currently has an exposure of around 50,000 crore to loans against shares, a form of credit enhancement often availed by promoters. These securities will need to carry a cover of 4:1, which typically now stands at 2:1.

Tyagi also said Sebi does not recognize standstill agreements between mutual funds and company promoters.

“We have started adjudication proceedings against two fund houses where two fixed maturity plans (FMPs) were impacted. As and when these cases (violations) come to light, the same direction will be followed for all cases. Our position is very clear," said Tyagi.

Sebi has served showcause notices to Kotak Mutual Fund and HDFC mutual fund. Currently, 12 FMPs of ICICI Prudential Mutual Fund and 12 FMPs of Aditya Birla Sun Life Mutual Fund are maturing but only after September, when the standstill agreement comes to an end, according to data on 28 February.Many of them are maturing as far as 2020. It will also be mandatory for all mutual fund schemes post September 2020 to invest only in listed non-convertible debentures and commercial papers, a measure aimed at more transparency.

“Going from unlisted to listed is not difficult, it just requires more disclosures," said Tyagi.

Industry experts said that a sizeable number of mutual funds have voluntarily adopted the changes that were introduced on Thursday. “Most of the regulatory changes were already brought into effect by mutual funds," said a fund manager, who did not wish to be identified. “Liquid funds already invest 10-15% in bills, which is a cash equivalent. The mark-to-market rule will not be immediately enforced, I expect it will take 6-9 months. The hike of cover to four times for credit enhanced securities will make the loan against shares market for MFs unviable. Promoters anyway get loans against 2x cover from NBFCs."

Liquid and overnight schemes cannot invest in short-term debt and money market instruments, according to the new rules.

If investors exit liquid schemes within seven days, then they will be subjected to an exit load.

Sebi has also finalized a uniform valuation policy for debt instruments. Currently, once the security falls below the investment grade, fund managers end up writing off papers as per their discretion. The new valuation framework hopes to do away with that. Own trades or so-called self trades will also not be allowed to boost valuation of the paper.

“The Sebi decisions are in line with their efforts to de-risk liquid funds. The most significant one is the 20% cash holding requirement. The seven-day exit load will also drive many small corporates, who keep money for very short periods, to overnight funds," said Avnish Jain, head of fixed income at Canara Robeco Mutual Fund.

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