SEBI Chairman Proposes Additional Measures to Make Debt Mutual Funds Safer

[Read: COVID-19 Related Disruption Causes Franklin Templeton Mutual Fund to Wind-down Six Debt Schemes]

This experience brought to light structural issues related to the corporate bond markets and also revealed scope of improvement in respect of the practices followed in the mutual fund industry.

Market regulator thus stepped in to ease some pain off mutual funds by undertaking steps to improve liquidity and make the transaction more transparent from investors' point of view:

Here are some of the steps taken by SEBI over the past couple of years to make debt mutual funds less risky:

1. Liquid funds are mandated to hold at least 20% of their AUM in liquid assets such as cash, G-secs, T-bills

2. Valuation of debt and money market instruments are to be done on mark to market basis

3. Cap on sectoral limits reduced to 20% from 25%

4. Mandate to invest primarily in listed debt securities

5. Option to segregate downgraded papers, restructured debt, from rest of the portfolio

6. Fortnightly disclosure of portfolio

7. More comprehensive details of the scheme's transaction on daily basis

8. Allowing Credit Risk Funds, Corporate Debt Funds and Banking and PSU Debt Funds to include G-secs and T-Bills in the core asset allocation as a temporary measure to meet heightened redemption requests

Recently, while addressing AMFI's 25^th AGM, SEBI Chairman Ajay Tyagi said that regulator is considering taking additional steps to help debt mutual funds be better prepared while dealing with crisis and to address liquidity concerns.

Some of the measures under consideration to address illiquidity in corporate bond market are as follows:

1) Stress testing

SEBI is facilitating the setting up of an expert committee to frame a stress testing methodology, encompassing liquidity, credit and market risks, for all open-ended debt oriented mutual fund schemes. Stress test would help AMCs to evaluate the impact of the aforementioned risks on the scheme's NAV. If the stress test reveals any vulnerability or early warning signal, AMCs will be able to take corrective action and mitigate the impact on the portfolio.

The market regulator will also design a framework to determine the minimum asset allocation required in liquid assets, taking into account the nature of scheme's assets, type of investors, outcome of stress testing, minimum redemption requirement during gating, etc.

2) Swing Pricing

In case of heightened redemption pressure, mutual funds are forced to liquidate high quality papers to meet the demand. Consequently, the scheme is left with concentrated portfolio of illiquid assets. This benefits exiting investors at the cost of those who continue to stay particularly in case of stressed situations. To deal with this, SEBI has proposed Swing Pricing / Anti-dilution levy to pass on the cost of transaction cost to the transacting investor undertaking large redemption in time of crisis.

3) Repo in corporate bonds

Mutual funds are one of the largest players in the secondary market corporate bonds and commercial papers (CPs). However, mutual funds often find it difficult to get a sizeable counterparty to cater to their buying/selling need. Thus, SEBI feels there is a pressing need to increase liquidity in the corporate bond market to ensure smooth functioning of the debt mutual funds.

While SEBI has already mandated mutual funds to do a minimum percentage of their secondary market trades in corporate bonds on the RFQ platform of stock exchanges to address the said issue, it is considering repo in corporate bonds to not only increase liquidity in secondary markets but also to enable greater issuances of paper rated below AAA.

Repo is transaction by which the borrower takes loan against an asset (instrument) to another party with a promise to repurchase it on a future date at a higher price. The asset therefore, serves as collateral. This means that mutual funds will be able to borrow money against their securities in times of crisis without having to sell them at a discounted price.

SEBI is deliberating on having a limited purpose central clearing corporation for guaranteed settlement of tri-party repo trades in all investment grade corporate bonds, including those below AAA rated, to boost repo trading in corporate bonds.

4) Back-stop facility

During heavy redemption pressure, selling debt papers, especially low-rated ones, becomes a challenging task due to risk-aversion among buyers. SEBI has suggested setting up an entity that would buyout illiquid corporate bonds from debt funds in times of stress. This could help instill greater confidence of market participants in corporate bonds, especially in below AAA investment grade bonds.

Will the measures benefit debt fund investors?

SEBI's proposed measures have addressed some of the important concerns of the mutual fund industry such as illiquidity in corporate bonds and steps to be taken in extreme situations. However, do note that these steps have not been implemented yet and it could be a while before it comes into force.

Therefore, it is important to be extra cautious while selecting debt funds to invest in. Given the rising credit risk amid weak economic growth it would be prudent to stay away from funds with high exposure to private issuers.

Invest in debt funds that have a predominant exposure to government bonds or quasi-government papers because these can offer better safety and liquidity.

[Read: Why You Need To Be Extra Careful While Selecting Debt Mutual Funds Now]

To select a scheme, essentially assess your risk appetite and investment time horizon, plus factors such as:

• The portfolio characteristics of the debt schemes

• The average maturity profile

• The corpus & expense ratio of the scheme

• The rolling returns

• The risk ratios

• The interest rate cycle

• The investment processes & systems at the fund house

At PersonalFN, we arrive at top rated funds using our SMART Score Model. If you wish to select worthy mutual fund schemes, I recommend that you subscribe to PersonalFN's unbiased premium research service, FundSelect.

Additionally, as a bonus, you get access to PersonalFN's popular debt mutual fund service,  DebtSelect.

If you are serious about investing in a rewarding mutual fund scheme, Subscribe now!

Warm Regards,
Divya Grover
Research Analyst

Join Now: PersonalFN is now on Telegram. Join FREE Today to get 'Daily Wealth Letter' and Exclusive Updates on Mutual Funds