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Debt fund investors in India have been grappling with credit risk since the IL&FS fiasco first came to light in September 2018. The liquidity and debt crisis in one of the largest NBFC in India led to the downgrading of its credit rating from `AA+' to `D' within few months.

Soon other companies in similar crisis came to the light, which included DHFL, Essel Group, and Reliance ADAG Group. Mutual funds had exposure to debt papers of such companies as well as the companies backed by the promoters of such troubled firms. Consequently, fund houses had to write-off their investments and this impacted the NAV of those schemes.

In June 2019, SEBI had announced a host of changes related to liquid and other debt mutual funds to make these schemes more transparent and safer for investors. It has now finalised the draft amendments to the prudential norms for mutual fund schemes for investment in debt and money market instruments.

[Read: Are You Holding Debt Mutual Funds With Stressed Assets?]

It is to be noted that all listed debt instruments are mandatorily rated. Mutual funds' investment in unrated debt instruments are mostly in fixed deposits, bills re-discounting (BRDS), mutual fund units, repo on corporate bonds, units of Real Estate and Infrastructure Investment Trusts (REITs/InvITs ), etc.

SEBI has separate norms for fixed deposits (FDs), mutual fund units, repo of corporate bonds, and REITs/InvITs; and the exposure to these instruments does not form part of the existing 25% investment cap.

Therefore, excluding these instruments, the total exposure of mutual funds in unrated debt instruments is mainly in BRDS. As per media reports, the exposure of mutual funds in BRDS as on March 31, 2019 was about Rs 2,870 crore. Besides, only four mutual fund schemes have investments in BRDS and its value as percentage of the respective scheme's asset under management was just around 3%.

SEBI is therefore of the view that the existing limit of 25% in unrated debt instruments would be too high.

[Read: Will Rating Reform Make Investing in Debt Mutual Funds Safe?]

In addition, some further amendments have been proposed for approval of SEBI's board during its next meeting. One such proposal is to dispense with the existing provision of the single issuer limit of 10% for investment in unrated debt instruments.

As per SEBI officials, the proposed limits may need to be reviewed periodically by SEBI after taking into account the market dynamics and participation of mutual funds in unrated debt securities from time to time.

The SEBI board has already given its 'in-principal' approval for the valuation of debt and money market instruments completely on mark-to-market basis with effect from April 1, 2020. Besides, mutual funds would be permitted to accept upfront fees, though they will have to disclose such fees to valuation agencies. Standard methodology for treatment of such fees would be issued by the industry body AMFI (Association of Mutual Funds in India) in consultation with SEBI.

SEBI will soon issue a circular on operational aspects of the proposal such as timelines, grandfathering of existing investments, exclusion of exposure in debt instruments such as interest rate swaps, etc.

SEBI has assiduously taken the regulatory measure in the interest of the investors and can help revive their confidence in this gloomy market environment. The regulator's risk management framework, ratings reforms, and other steps will discourage mutual funds from taking excessive risks.

[Read: Should MFs Join ICA To Safeguard Investors Against The DHFL Debt Mess?]

Investors must remember that debt instruments are not safe. Therefore, investors must consider their risk appetite, financial goals, and investment horizon before investing in debt scheme. Ideally, you should invest only in schemes that have a maturity profile matching your time horizon, to avoid negative surprises.

Be cautious of schemes that have exposure to the debt of stressed companies. Last but not least, invest only in debt schemes offered by mutual fund houses which follow robust investment processes and have adequate risk management systems in place.

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