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Photo: iStock

Will more govt debt in mutual funds benefit you?

Debt mutual funds having more government securities will be more liquid

Earlier this week, capital markets regulator Securities and Exchange Board of India (Sebi) allowed certain categories of debt funds to invest up to 15% more of their assets in government debt, which is the most liquid form of debt in the Indian debt market. The move will help mutual funds build up liquidity to face huge redemptions. The facility has been provided to credit risk, corporate debt and banking and PSU debt funds for up to three months from the date of the circular (18 May).

Why was this necessary?

Open-ended funds allow investors to enter and exit at any time, although many have exit loads. Redemptions in debt funds increased in April after the covid-19 lockdown was announced and then shot up dramatically post the winding up of six Franklin Templeton Mutual Fund schemes on 23 April. Debt funds (excluding liquid and overnight) saw an outflow of around 9,000 crore in just three working days following the Franklin announcement, according to data from the Association of Mutual Funds in India (Amfi).

When redemptions increase but the holdings of a mutual fund cannot be sold, a liquidity problem arises. In such a scenario, the fund can borrow money, but only up to 20% of its assets. Hence, it is important to have highly liquid securities such as government bonds in the portfolio to some extent. To avail of this facility, asset management companies (AMCs) need to seek approval from AMC boards, trustee boards and internal investment committees.

Category selection

One of the categories chosen, credit risk funds, saw large outflows. The other two, corporate debt and banking and PSU debt funds, have been chosen as a measure of precaution.

Credit risk funds have seen maximum redemptions as a proportion of their assets. Their size fell from around 48,000 crore on 24 April 2020 to around 35,000 crore by 15 May. These funds are required to invest at least 65% of their assets in papers rated below AA+ that tend to be highly illiquid. A reduction in such papers to 50% and a proportionate increase in government debt will help funds meet redemptions without resorting to extreme measures.

Corporate bond funds have to invest at least 80% of their assets in AA+ and above bonds which tend to be more liquid. Banking and PSU funds have to invest at least 80% of their assets in debt issued by banks and public sector units (PSUs). Sebi has allowed them to reduce these limits to 65% each. On the face of it, this seems unnecessary, because AAA corporate and banking and PSU debt is relatively liquid and low risk. In fact, corporate bond and banking and PSU debt funds did not witness significant redemption pressures.

However, according to Feroze Azeez, deputy CEO at Anand Rathi Private Wealth, there could be redemptions in these funds going forward. Investors who have seen job losses, pay cuts or reductions in sales (if they are self-employed) may need to draw down their savings in such funds. Also, even AAA or AA+ corporate bonds can get suddenly downgraded, sparking a liquidity crisis. So this relaxation is largely a precaution.

“This won’t change the duration profile of schemes much. Schemes will simply pick government debt that is best aligned with their existing maturity profile," said a fund manager at a mid-sized fund house, on the condition of anonymity.

Does this work for you?

“This precautionary measure by Sebi is good for all three debt categories," said Azeez. Your debt funds can take advantage of this relaxation to become more liquid. This is a big positive for you in times like these when the ability to withdraw your own funds is of utmost importance.

But will your returns get affected? The effect on returns is mixed because, on the one hand, government debt has lower yield and, on the other, debt fund managers will get more flexibility on when to deploy the money in corporate debt. According to Azeez, the possible negative impact on the returns of treasury bills (a form of government debt) compared to corporate bonds on an annual basis is just around 0.17%. He suggested that AMCs should still reduce their expense ratios to compensate investors for this amount.

Rajeev Radhakrishnan, head, fixed income, SBI Mutual Fund, pointed out the benefit of flexibility. “Banking and PSU debt and corporate bond funds can deploy money into government bonds without compulsion of immediate deployment in their focus areas," he said. Before the circular, such schemes had to immediately comply with their mandates with 80% of corpus in banking and PSU or corporate debt or 65% of corpus in debt below AA+ (in case of credit risk funds). Now they can keep fresh money in government bonds until they find favourable opportunities in the corporate or banking debt market.

This greater flexibility can allow them to generate high returns.

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