How the Capital Regulator is Proactively Ensuring That Debt Funds Remain Liquid

The market regulator, SEBI, decided to become proactive on how the debt mutual fund portfolio is created.

When the Franklin news was out, plenty of redemptions occurred, illiquidity issues were faced leaving the top fund house to take a decision that didn't go down well with investors, as they saw an erosion of their wealth.

Usually when a redemption increases, in order to control the shortfall, a fund is allowed to borrow for upto 20% of its assets, only after the approvals from AMC boards, trustee boards and internal investment committees. Thus, government bonds are the only ones that can provide some easy liquidity.

Hence, the regulator tweaked the limit of 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.

[Read: Is Your Liquid Fund Really Safe and Liquid?]

Prime categories are...

Credit risk funds, Corporate debt funds, and Banking and PSU funds usually have high allocation to debt instruments issued by private entities and are below 'AA' rated papers.

Credit funds were mandated 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.

Whereas corporate bond funds have to invest at least 80% of their assets in AA+ and above in bonds which tend to have more liquidity. The Banking and PSU funds must invest at least 80% of their assets in debt issued by banks and public sector units (PSUs). The regulator has now allowed them to reduce these limits to 65% each.

Since both these funds hold AAA rated corporate and banking and PSU debt instruments that are relatively liquid and low risk.

How will this help?

To begin with, the defaulting episode has caused far too much damage, whose echoes are still heard despite the many stringent actions the regulator has taken.

Besides, the investments in government securities has increased in credit risk funds, corporate funds and banking and PSU funds that are AAA rated making them less risky. The credit risk funds had been unappealing for a very long time, now it might draw some inflows.

[Read: Here's Why Debt Mutual Funds Turned Unappealing]

How will it affect you as an investor?

The pandemic lockdown has further slowed the economic growth, with the rise in unemployement levels, paycuts, and probable increase in defaults in repayments to amplify credit risk.

So medium-scale and small-scale companies would have a hard time to keep up with their timely repayments and even the AAA debt rated instruments may get downgraded and turn toxic. Investors wouldn't want to lose any more of their hard earned money again through debt mutual fund investments, as they are "once bitten twice shy". Again, there might be a redemption pressure making so many of these funds to face liquidity issues.

This move focuses on addressing the liquidity issues so that even investors with reduced income due to a delay in salaries or those who are witnessing a pay cut or even loss of job can redeem their investments for their survival.

These mutual funds can now park more in government issued securities, so the risk of the individual category of schemes have reduced, not eliminated, but are more liquid without altering much of the overall average maturity of the scheme.

Keep in mind the returns would be a mixed bag because government bond yields have higher liquidity. This means that when you want to redeem your money, the fund house will not lock your fund and prevent you from redeeming it.

What should investors do?

Time and again, at PersonalFN we have highlighted the risk element involved in debt mutual fund investing. Looking at the widespread contagion of credit risk and mismanagement of fund houses, I believe. It is time to stay away from debt mutual fund schemes, particularly the ones holding toxic debt papers.

Keep in mind that when the underlying debt security held by a debt mutual fund scheme is downgraded or its issuer stops servicing the debt (or defers payments), the Net Asset Value (NAV) of a debt scheme takes a knock. If the redemption pressure mounts when a security gets downgraded, it results in further losses as the fund house struggles with liquidity issues to facilitate large-value redemptions and ends up selling high-rated instruments.

Similarly, when a paper is upgraded, the debt scheme adds back the earlier markdown, and as a result, the NAV increases. But then, the positive impact on the scheme's NAV depends on the extent of the upgrade; if it is insignificant, it fails to generate meaningful returns for debt fund investors.

The COVID-19 pandemic has caused dislocations in terms of credit risk and liquidity. Please note debt mutual funds are not risk-free or safe. The risk you are exposed to depends on the portfolio characteristics of the debt scheme, i.e. the type of debt papers, the issuers (private or government), the quality (AAA, AA+, AA, A etc.), portfolio concentration, maturity profile, etc. and whether or not a debt mutual fund scheme engages in yield hunting.

[Read: How Quantum Multi Asset Fund of Funds Protects the Downside Risk]

[Also Read: Make Mindful Choices of Mutual Fund investments in Current times]

Besides, pay attention to the following important factors to evaluate debt funds:

• ✓ The investment processes & systems and risk management measures at the fund house;

• ✓ The average maturity profile;

• ✓ The portfolio characteristics details of the debt scheme;

• ✓ The corpus & expense ratio of the scheme;

• ✓ The rolling returns;

• ✓ The risk ratios; and

• ✓ The interest rate cycle

Therefore, don't invest in debt funds unless you evaluate the above facets and fully recognise the risk involved.

It's time to follow a conservative approach. Consider only those debt funds that invest at least 80% of their assets in bonds floated by the Government of India and securities issued by public sector companies. For example, Banking & PSU Debt Funds that hold 85%-90% of its assets in instruments issued by major Banks and PSUs. Likewise, a Dynamic Bond Fund, which invests only in government securities and a few selected PSUs.

Our friends at Quantum Mutual Fund have highlighted the secret behind their debt management strategy, which has helped them provide safety and liquidity to investors when it comes to investing in Quantum funds. Don't Worry, Quantum Liquid Fund always aims for Safety and Liquidity.

Alternatively, if you prefer to keep your capital safe, opt for bank fixed deposits.

Happy Investing!

Warm Regards,
Aditi Murkute
Senior Writer

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