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How to really reform debt funds

Debt mutual funds in India have turned quite accident-prone since the IL&FS crisis. With schemes from different fund houses battered in turns by defaults from the IL&FS, Essel, DHFL and Reliance ADAG groups, investors have had to deal with quite a few unexpected jolts to their NAVs.

It is good to see that, unlike other financial product regulators, SEBI has not been content with wringing its hands and watching the crisis unfold from the sidelines. It has acted swiftly to announce multiple regulatory tweaks to plug the gaps in debt funds over the past year.

Regulatory reboot

To prevent debt funds from going overboard with their security or sector choices, SEBI has imposed a 10 per cent exposure limit on their individual bond holdings and a 20 per cent cap on exposures to a single sector or group. The special treatment to NBFCs has been reined in at the same 20 per cent allocation, with an additional 10 per cent for housing finance companies.

Grey areas in the valuation of thinly traded non-investment grade bonds have been painted over by ushering in a standard AMFI haircut matrix that lays down the standard write-downs that schemes need to take in the event of downgrades.

Mark-to-market valuation has been enforced across-the-board by requiring that all schemes, including liquid funds, use only market prices and not artificial amortisation, to value bonds with over 30-day tenors. Liquid funds have been cleaned up with a mandatory 20 per cent allocation to liquid instruments and an exit load to deter churn.

New side-pocketing norms dictate that debt funds which choose to segregate their troubled bonds must do so immediately after a downgrade and make standard disclosures. These regulatory changes were much-needed to tighten the lax risk control and valuation practices of debt funds, making the vehicle more transparent to investors.

Micro-managing investments

But having done all this, SEBI now seems to be turning its attention to micro-managing the investment choices of debt fund managers in a bid to make debt funds a ‘safer’ vehicle.

In its recent October 1 circular, SEBI has proposed a new set of restrictions on debt fund investments. One, mutual fund schemes will henceforth be restricted from investing in any unlisted corporate bonds including commercial paper, with unlisted NCDs expected to be capped at 10 per cent of each scheme by June 2020. This change will require AMCs to persuade issuers to list even short-term instruments such as commercial paper, apart from specially structured NCDs, on the bourses.

Two, investments in lower-rated bonds with external backing (structured obligations or credit enhancements) are to be capped at 10 per cent too. Should funds take on promoter lending deals with equity as collateral (about ₹1 lakh crore of current debt assets), SEBI insists on a security cover of at least four times. Given that very few promoters may be willing to meet this tall ask, this may effectively put paid to the lucrative promoter lending deals which helped prop up returns on a many a debt fund in the last decade. The net effect of these changes, as they take effect over the next one year, will be to substantially curb the ability of debt fund managers to differentiate themselves from their peers, or deliver high returns, by using credit strategies in their portfolios.

Big guys dominate

While SEBI’s new strictures may be aimed at making debt funds safer for the small investor, they aren’t ideal ways to reform the category on three counts.

One, debt funds in India, unlike equity funds, are mainly patronised by institutions and high net worth investors who have both the appetite and the financial wherewithal to take on higher risks for higher yields. Data from AMFI show that of the ₹11.5 lakh crore assets managed by debt funds in June 2019, retail investors (investing less than ₹2 lakh) held less than ₹50,000 crore, while HNIs accounted for ₹3.5 lakh crore. The lion’s share of debt fund assets (over ₹7.5 lakh crore) were held by corporate treasuries, banks and FIIs. The average ticket size of an investment in a debt fund was ₹14.6 lakh versus ₹1.25 lakh for an equity fund. Clearly, the average debt fund investor is not a babe in the woods when it comes to evaluating portfolio risks.

Two, given the paucity of high-yield options in the Indian debt market, even retail investors end up flocking to unregulated vehicles such as chit funds and unregulated bonds, or end up taking concentrated bets on NBFC NCDs or co-operative bank FDs, in their chase for returns. Warts and all, debt mutual funds certainly offer a more diversified and risk-controlled vehicle for these yield-chasing investors. If retail investors can be allowed to freely dabble in risky small-cap equity funds, there’s no reason why they should be protected from credit-focussed debt funds.

Three, for all their shortcomings, mutual funds are today the most active participants in the non-AAA segment of the Indian bond market. With other players such as the EPFO, insurers and pension funds beating a hasty retreat from lower rated bonds after the IL&FS fiasco, mutual funds also stepping away en masse can stall credit flow and crimp the development of India’s bond market, which has remained in a rudimentary state for decades.

Finally, while these interventions may better protect retail investors from credit risks, interest rate risks still loom large for retail investors who unwittingly invest in the wrong categories of debt funds.

Three ideas

The above facts suggest that SEBI must perhaps give debt fund managers a freer hand in their portfolio choices to suit the majority of investors in debt funds, while shielding the small guy from undue risk-taking. Four ideas may help achieve this.

One, today SEBI’s categorisation rules slice and dice debt funds mainly based on the duration of the bonds they own, while schemes across the maturity spectrum end up owning risky credit. This has led to retail investors burning their fingers on supposedly ‘safe’ categories such as liquid funds and short duration funds. SEBI must now insist that every category of debt funds carve out separate ‘retail’ options which are very conservatively managed for credit risks. Risky bets on promoter-backed or credit enhanced bonds can then be restricted to the plans patronised by the big boys.

Two, more than credit calls per se, it is the flouting of concentration norms by fund managers that has led to investors in debt funds suffering unacceptable NAV losses of 25-50 per cent. Funds claim that this happens due to a run on the scheme the moment there’s a default, forcing it to sell its good securities. SEBI must consider compulsory side-pocketing of bad bonds in debt schemes which overshoot their 10 per cent exposure norms. Where a defaulting security shoots up to over 25 per cent of the portfolio, a freeze on transactions and an orderly winding up may be called for.

Three, the current ‘riskometer’ on fund documents fails wholly in conveying how risks play out in debt funds. It must be replaced with a plain statement that investments in debt funds are subject to capital losses.

Four, AMFI awareness campaigns need to move away from highlighting the benefits of SIPs and the risks of going direct, to educating Indian investors about how market risks really work in debt funds. Retail investors who buy debt funds need to step in with the full knowledge that they’re dealing with a wholly different animal from a fixed deposit or post office scheme.

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