Reviewing the scenario of heightened credit risk in the Indian debt market and its impact on investors, the capital market regulator, SEBI has been continually taking a number of measures.
In the past, the regulator…
- Issued prudential norms governing liquid funds and other debt & money market instruments
- Prescribed graded exit load for liquid funds
- Changed valuation norms for below-investment grade securities
- Asked mutual fund houses to shift all their investment to listed or to-be-listed equity and debt securities in a phased manner and reduce their exposure to unrated debt instruments from 25% to just 5%
- And even pulled up credit rating agencies for their high laxity and enhanced their disclosure norms
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Marching ahead, very recently, SEBI has further refined valuation norms for debt and money market securities vide a circular.
Among a host of things, the regulator has prescribed a ‘Waterfall Approach’ to arrive at a security level pricing.
The principles adopted under the ‘Waterfall Approach’ as prescribed by SEBI are:
- All traded securities shall be valued on the basis of traded yields, subject to identification of outlier trades by the valuation agencies.
- The Volume Weighted Average Yield (VWAY) for trades in the last one hour of trading shall be used as the basis for valuation of Government Securities (including T-bills). Valuation of all other money market and debt securities (including Government securities not traded in last one hour) shall be done on the basis of VWAY of all trades during the day.
- In case of any exceptional events on a day, only VWAY of trades post such event may be considered for valuation. Further, all exceptional events along-with valuation carried out on such dates shall be documented with adequate justification.
- All trades on stock exchanges and trades reported on trade reporting platforms till the end of the trade reporting time (excluding Inter-scheme transfers), should be considered for valuation on that day. Towards this end, the timing for disclosure of Net Asset Value (NAV) stands extended upto 11:00 p.m. for uploading the NAVs of all schemes (except Fund of Fund schemes) on the website of AMFI and respective AMCs.
Further, considering the importance of polling in the valuation process, the capital market regulator has directed the Association of Mutual Funds in India (AMFI) to issue guidelines on polling by valuation agencies — who will also be appointed by AMFI.
Plus, AMFI is expected to issue guidelines on the responsibilities of mutual fund houses (or Asset Management Companies) in the polling process, as part of the aforesaid Waterfall Approach.
The SEBI circular says the guidelines shall inter-alia include the following…
- Valuation agencies shall identify the Mutual Funds who shall participate in the polling process on a particular day, taking into account factors such as diversification of poll submitters and portfolio holding of the Mutual Funds. Mutual Funds who are identified by the valuation agencies shall necessarily participate in the polling process. However, in case any Mutual Fund does not participate in the polling process, detailed reason for the same shall be recorded and made available during SEBI inspections.
- The minimum number of polls to be considered for valuation along-with the operational modalities of polling shall be specified.
- AMCs (Asset Management Companies) shall have a written policy, approved by the Board of AMC and Trustees, on the governance of the polling process. The aforesaid policy shall include measures for mitigation of potential conflicts of interest in the polling process and shall identify senior officials responsible for polling.
- AMCs shall ensure that participation in the polling process is not misused to inappropriately influence the valuation of securities. The officials of the AMC, who are responsible for polling, shall also be personally liable for the polling process.
- AMCs shall maintain an audit trail for all polls submitted to valuation agencies.
- The aforesaid waterfall approach shall form part of the valuation policy of individual AMCs which is uploaded on their respective websites. AMFI shall ensure that the said waterfall approach is also available on the website of the valuation agencies.
The capital market regulator has asked AMFI to ensure that valuation agencies have documented the Waterfall Approach and that it should be done in consultation with SEBI.
Notwithstanding the above, SEBI has also updated the definition of traded and non-traded money market and debt securities as under:
- A money market or debt security shall be considered as traded when, on the date of valuation, there are trades (in marketable lots) in that security on any recognized Stock Exchange or there are trades reported (in marketable lots) on the trade reporting platform of recognized stock exchanges or The Clearing Corporation of India Ltd. (CCIL). In this regard, the marketable lots shall be defined by AMFI, in consultation with SEBI.
- A money market or debt security shall be considered as non-traded when, on the date of valuation, there are no trades (in marketable lots) in such security on any recognized Stock Exchange or no trades (in marketable lots) have been reported on any of the aforementioned trade reporting platforms.
Further, since the valuation methodology for thinly traded debt securities is same as non-traded debt securities, SEBI has done away with a separate definition of thinly traded debt securities.
Do note that the circular states that the concept of Non-Performing Assets (NPAs) may not be relevant for the mutual fund industry, and hence the guidelines for identification and provisioning of NPAs has been deleted and replaced with securities classified as “below investment grade” or “default”.
For valuation of securities “below investment grade” and “default”, the capital market regulator has stated:
- A money market or debt security shall be classified as “below investment grade” if the long term rating of the security issued by a SEBI registered Credit Rating Agency (CRA) is below ‘BBB-’ or if the short term rating of the security is below ‘A3’.
- A money market or debt security shall be classified as “Default” if the interest and / or principal amount has not been received, on the day such amount was due or when such security has been downgraded to “Default” grade by a CRA. And in this respect, the mutual funds shall promptly inform the valuation agencies the CRAs, any instance of non-receipt of payment of interest and/or principal amount (part or full) in any security.
The regulator has even gone on to define the treatment of accrued interest, future interest accrual and future recovery, in case of money market and debt securities classified as “below investment grade” or “default”. It is detailed as below:
- The indicative haircut that has been applied to the principal should be applied to any accrued interest.
- In case of securities classified as “below investment grade” but not default, interest accrual may continue with the same haircut applied to the principal.
- In case of securities classified as “default”, no further interest accrual shall be made.
As regards using own trades for valuations, it has come to the regulator’s notice that Mutual Funds have used their own trades of relatively small quantity in order to value the entire holding of such security.
In order to prevent possible misuse, it is prescribed mutual funds not to use their own trades for valuation of debt and money market securities and for Inter-Scheme Transfers (ISTs).
If the mutual fund house makes a change to the terms of investment, which in turn may have an impact on valuations, the regulator has said that it will be required to be reported to the valuation agencies immediately.
There are many more facets and fine points that SEBI has prescribed to value money market and debt securities. To access the circular, click here.
The broader objective of the aforesaid guidelines is to ensure that the mutual fund industry follows the best practices, whereby the robustness of valuation of debt & money market securities improves.
What if there is a deviation?
As per the principles of Fair Valuation specified in the Eighth Schedule of SEBI (Mutual Funds) Regulations, 1996, mutual fund houses or AMCs will be responsible for true and fairness of valuation and correct NAV.
And in case if the AMC decides to deviate from the valuation price (given by the valuation agencies), the instance of deviation needs to be recorded along with detailed rationale for each by the AMC, going by the SEBI circular.
The impact on debt mutual funds…
Mutual fund houses are expected to strictly adhere to these guidelines in the interest of their own risk management and to safeguard debt mutual fund investors. Risk management would improve. That being said, it does not make investing in debt mutual fund safe.
Remember, investing in debt funds is not risk-free.
How to approach debt mutual fund schemes?
Approach debt mutual fund schemes with your eyes wide open. Pay attention to traits of the sub-category of debt mutual fund scheme you are considering and its portfolio characteristics.
Prefer the safety of principal over returns. Stick to debt mutual funds where the fund manager doesn’t chase returns by taking higher credit risk. The fact is that many debt mutual funds across maturity profiles are grappling with downgraded and toxic debt papers which heighten the investment risk.
And last but not the least; assess your risk appetite and investment time horizon while investing in debt funds.