In a caustic remark, SEBI chief Ajay Tyagi reminded mutual funds of their core objective, and rightly so. “Mutual funds investment is different from bank lending and it needs to have elements of safety as well as investment.”

Mutual fund houses indeed gave a long rope to promoters of troubled companies at the cost of investors. At the board meeting, the capital market regulator introduced a slew of new regulations that intend to make debt mutual funds a lot safer place for investors.

Risk management practices that will change for debt funds are:

#1: Liquid funds will now have to hold at least 20% of their assets in highly liquid assets such as cash, government securities, and repo.

Implication: Even in the case of any unforeseen liquidity crunch, liquid funds will be able to honour redemptions. The highly liquid nature of their portfolio would make liquid funds a safer but less rewarding space for investors.

#2: Debt funds cannot invest more than 20% of their assets in any sector. Earlier, this limit was 25%. The market regulator has also reduced the additional exposure to Housing Finance Companies (HFCs) to 10% from 15% earlier. Moreover, debt funds can invest only 5% of their assets in securitised debt based on retail or affordable housing loan.

Implication: Debt fund portfolios would look less skewed. Investors would be less exposed to risks arising out of sectorial concentration. High exposure of debt funds to NBFC sector has been one of the primary factors behind the on-going credit crisis.

#3: All debt and money market instruments will have to value their portfolio on mark-to-market basis now.

Implication: Earlier valuation/s based on amortization was permitted up to 60 days of residual maturity. In the wake of the on-going credit crisis, there were suggestions to make mark-to-market valuations compulsory for all instruments with a residual maturity of more than 30 days. However, SEBI’s decision of obsoleting valuations based on amortization would make the NAVs of debt funds more transparent.

#4: Liquid and overnight funds won’t be able to invest in short-term deposits, debt, and money market securities having structured obligations or credit enhancements.

Implication: The universe of permissible investment instruments for liquid funds has become smaller now. However, this will safeguard investors from getting exposed to higher credit risks through liquid and overnight funds.

#5: Exits from liquid schemes within 7 days of investing would now attract graded exit loads.

Implication: This rule will discourage investors from exiting liquid funds within the first 7 days, thereby offering fund managers more breathing space in portfolio construction. Those investing in liquid fund will need to ensure that their investment time horizon is at least 7 days.

#6: Mutual Fund schemes shall be mandated to invest only in listed NCDs and this would be implemented in a phased manner. All fresh investments in Commercial Papers (CPs) shall be made only in listed CPs pursuant to issuance of guidelines by SEBI in this regard.

Implication: In case of mutual funds investing in unlisted securities, exiting them becomes a tough task when they fail to find ready buyers. In contrast, listed NCDs and CPs may have slightly better liquidity profile as compared to their unlisted peers.

#7: Mutual fund schemes can’t invest more than 10% of their assets in debt and money market instruments with credit enhancements and group exposure to such securities can’t be more than 5%.

Implication: Capping exposure on debt instruments with credit enhancements will make it impossible to mask the risk with unreliable credit enhancement thereby offering more security to investors.

#8: There should be adequate security cover of at least 4 times for investment by Mutual Fund schemes in debt securities having credit enhancements backed by equities directly or indirectly.

Implication: This rule will safeguard mutual funds and investors alike from a sudden fall in the stock prices offered for credit enhancements. It will also discourage companies from utilising equity shares to secure enhanced credit; as the sanctioned amount would be relatively lower compared to the cover required for the enhancement.

In a nutshell

SEBI has taken a tough stance against mutual fund houses that took investors for a royal ride so far. It’s time for them to introspect. SEBI’s restructuring of risk management framework will discourage mutual funds from taking excessive risk and mask them with complex credit structures.

Will debt funds stop giving nasty surprises?

Hopefully, yes!

This article first appeared on PersonalFN here.

by PersonalFN Content & Research Team

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