In a speech at the Association of Mutual Funds in India’s (Amfi) annual general meeting on Tuesday, the Securities and Exchange Board of India (Sebi) chairman Ajay Tyagi outlined proposals under consideration of the regulator that look to reduce risks in debt mutual funds. We explain what they are and how they can achieve this purpose.
Repos in corporate bonds: A repo operation is a lending operation. The borrower offers security and takes a loan for a certain period of time. Repos with government bonds as collateral are common in the Indian debt market, but this is not so for corporate bonds.
Tyagi announced that Sebi was considering setting up a central clearing corporation for repos in investment grade (BBB or higher) corporate bonds with guaranteed settlement. This can allow mutual funds to borrow money against their assets when redemptions are high without having to sell them at throwaway prices.
“Repos in corporate bonds need two things to pick up. First, a standardized exchange-based system so that repo documentation doesn’t have to be repeated again and again. Second, a clearing corporation that will take custody of the collateral and guarantee trades. Even if the first point is implemented, it can greatly improve liquidity in the corporate bond market,” said Rajeev Radhakrishnan, head, fixed income at SBI Mutual Fund.
Creation of a backstop: Tyagi outlined the possibility of creating a backstop mechanism—an entity to buy illiquid debt during times of crisis. The corporate debt market in India is relatively illiquid even in normal conditions and a crisis aggravates this situation, making it difficult for debt fund managers to honour redemptions. However, the chairman did not outline how this entity would be funded.
Minimum cash holding in debt funds: Current Sebi rules mandate liquid funds to hold at least 20% of their assets in cash (or equivalents such as treasury bills). However, there are no such rules for other kinds of debt funds. Sebi announced the constitution of a committee to study the matter and also that interim rules will be framed till the committee gives its recommendations taking into account the recommendations of the Mutual Fund Advisory Committee (MFAC).
“Having all debt funds, not just liquid, keeping some portion of their portfolio in liquid paper like T-bills is a welcome step. This is something we do already in our debt schemes, apart from the liquid fund where it is mandated,” said Radhakrisnan.
However, a debt fund manager at a mid-sized fund house expressed apprehensions about the move. “Asking debt funds to keep, say 10-20%, in cash can take a major toll on returns. This is especially true for long-duration funds,” the fund manager said, requesting anonymity.
Swing pricing: Swing pricing is a technique that imposes costs on investors giving large redemptions in debt funds in times of crisis. Costs are imposed on such investors when they pull out money, and hence, they may not get redemption exactly as per the fund’s net asset value (NAV).
“It is a concept applied internationally where large investors exiting or entering a fund get a price or NAV that more truly reflects the underlying debt portfolio transactions. It may be applied in India also, but note that it is only used in very extreme situations,” explained Radhakrishnan.
Taken along with other Sebi measures to reduce debt fund risks such as limits on credit enhanced securities in the portfolio, the four proposals can go a long way towards making debt funds safer.
However, there are some concerns about such policies triggering a flight of institutional investors from debt funds.
“Cumulatively, all these measures will push large treasuries away from debt funds for short term needs. The stamp duty, for example, also has this effect. Mutual funds will be more a place for high net-worth individuals and retail investors, even debt MFs. Currently, almost 90% of the money in liquid funds and around 50% in other debt schemes is institutional money,” said the aforementioned fund manager who declined to be named.
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