A holistic approach for bond funds in India

Risk management is at the core of managing a fund. When the underlying securities in a fund are frequently traded in an orderly market, their discovered prices help in assessing and managing the risk in the fund. Investors are then comfortable transacting in the units of the fund. Unfortunately, the corporate bond market in India is very thin and does not provide continuous prices of most bonds below the AAA-rated ones. We have to live with this systemic deficiency until we have a deep and liquid bond market.

However, this does not mean that we do not try to find solutions for better price discovery. The marked-to-model technique is commonly used across the globe, including in India, for the valuation of non-traded bonds. However, quite often, it suffers from a lack of accuracy or stability in matching with the marked-to-market price, if there is an occasion to test it.

Valuation: The most difficult part of valuing an illiquid bond is the assessment of its illiquidity discount in the price. The problem with computing such a discount is that it is state-dependent, to use a technical term. In simple words, the discount varies with the status of the market, as well as the issuer of the bond. The bond market may be in a normal or stressed condition. Similarly, the issuer may be in a state of a going concern or liquidation. The latter states, for both the market and the issuer, increase the illiquidity discount in a non-linear manner.

Practitioners as well as academics have been toiling for long to model this. One of the recent journal papers (bit.ly/35ecTOc) in 2016 by Abudi and Raviv of Bar-Ilan University of Israel estimated the upper bound for the illiquidity risk of bonds. The authors have concluded that the illiquidity discount depends on duration, asset risk, and the leverage ratio of the issuer firm. However, it does not offer a composite predictive solution.

Fairness: The valuation of the bonds in an open-ended mutual fund becomes doubly difficult on account of the necessity of fairness. The financial accounting of the net assets of an ordinary firm follows the principle of conservatism. It is accepted, and even recommended, that the firm should carry its assets at a conservative value, in case of any doubt. This may lead to an undervaluation of its net assets, but is accepted for various reasons, which is a subject of another discussion.

On the other hand, the net assets in a mutual fund need to be valued fairly, and not conservatively. This is required because the units of the fund are bought and sold on a daily basis. Hence, the fund must ensure that buyers as well as sellers of its units pay or receive the fair value. If the net asset value (NAV) is understated, buyers would gain at the expense of existing investors. If this becomes widespread, in the case of an open-ended fund, it will lead to a run on the fund.

Hence, it is not enough for a fund to estimate its NAV in a conservative or a range-based manner. It must price its units accurately for every transaction.

Regulation: The Securities and Exchange Board of India (SEBI), in its guidelines for the valuation of mutual fund units, holds the asset management company (AMC) of a fund as primarily responsible for the valuation of debt securities and the computation of NAV. The AMCs, in turn, appoint third-party valuation agencies for providing them with the valuation. While the responsibilities have been fixed, the guidelines do not mention anywhere about the disclosure to the investors on the process of valuation. The latest circulars of March 2019 and September 2019 also are silent on this issue.

It is a cardinal principle of regulation in the area of financial markets that those holding fiduciary responsibility must disclose to the stakeholders all material risks known to them. The lack of accurate valuation of bonds is a material risk, and one that should be well understood by the funds. In such a scenario, the AMC should is expected to make periodic disclosures and take other related steps to mitigate the risk of imperfect valuation of illiquid securities.

The ratings issued by credit rating agencies are merely their opinion, and yet, their methodology and outcomes are overly regulated. However, the methodology for valuation of illiquid securities is neither available for discussion nor is appropriately regulated.

To conclude, there are significant systemic gaps in the functioning and regulation of bond funds. These need to be closely examined by SEBI, because bond funds are an integral part of the financing and investment chain of our economy. The issues in the valuation of illiquid debt securities as well as the management of mutual funds should be looked at in a composite manner.

The author is an associate professor at Bhavan's SPJIMR.