Ever since the IL&FS default crisis, an increasing number of instances of toxic debt papers in debt mutual funds are coming to light. Consequently, the number of side-pockets created by debt funds to segregate such toxic papers from the main portfolio has been on the rise. While this has been going on for a while, the recent event of Franklin Templeton MF where six debt schemes were wound-up due to liquidity crunch and redemption pressures came as a big jolt to the industry and its investors.

Investors have been treading with caution while approaching debt funds which led to heightened redemption across various categories over the past few months. Since then, there has been a rush to fix debt funds.

On this backdrop, SEBI has set up a working group to assess the best practices that will ensure better management of liquidity risk in open-ended debt funds. This working group will be chaired by Mr Ananth Narayan, Associate Professor at SPJIMR and a member of SEBI’s Mutual Fund Advisory Committee.

Among the members of this working group are representatives from the mutual fund industry, including current AMFI chairman Mr Nilesh Shah (MD & CEO, Kotak Mahindra AMC), Mr NS Venkatesh (CEO, AMFI), Mr Amit Tripathi (CIO-fixed income, Nippon India AMC), Mr Anil Bamboli (Fund manager, HDFC AMC), Mr Maneesh Dangi (CIO-debt, ABSL MF), and Mr Mahendra Jajoo (CIO-fixed income, Mirae AMC).

One of the key considerations of the working group will be to ensure that open-ended debt schemes have enough liquidity to absorb redemption pressures. For this, the group will assess whether a minimum 10% exposure in liquid assets such as government securities, cash, treasury bills, and tri-party repo should be mandated.

Another key consideration will be gating of redemptions to prevent any pressure on the fund. This means, that in the event of heightened redemption, the fund manager will have the ability to limit or halt redemptions if it rises beyond a certain specified limit.

Furthermore, the working group will assess whether the side-pocket creation norms need to be revisited and whether the introduction of side-pockets has given the fund managers more leeway to invest in riskier assets.

Apart from this, the working group will consider mandatory stress testing of all open-ended schemes. AMCs conduct the stress test to evaluate the impact of various risk parameters such as interest rate, credit risk, liquidity, and redemptions on the scheme’s NAV. In the event of the stress test revealing any vulnerability or early warning signal, AMCs are required to bring it to the notice of the trustees and take corrective action. At present, stress testing is mandatory only for liquid and money market schemes.

Will the new norms make investing in debt funds safe?

Funds will find steps such as having a mandatory liquidity buffer helpful when dealing with redemptions; however, it does not address the issue of some funds exposing investors to high credit risk. Moreover, it does not resolve the problem of an increased concentration of some assets in the portfolio, after redemption pressure, for the investors who chose to remain in the scheme.

Gating norms will come as a relief to AMCs, but for investors, it will take away the essence of open-ended schemes, which requires it to be open for subscription and repurchase at all times.

Stress testing on the other hand can be helpful in risk management for AMCs, provided it is conducted regularly. It is beneficial if the fund is quick to act in case the test reveals vulnerability or early warning signs.

To ensure better safety and liquidity, SEBI needs to tighten norms and define more clearly the scope of minimum investment requirement concerning credit quality and duration. For example, low duration funds should not be permitted to invest in low-rated instruments and/or securities having longer maturity of say 7-10 years.

Case in point, Franklin India Ultra Short Duration, one of the six shuttered schemes by the AMC, is required to invest in instruments with Macaulay duration between 3 months and 6 months. However, the fund will take around 5 years to repay its investors because the maturity of some underlying securities is much longer (around 4-5 years), even though the scheme belongs to low duration category. This is how it exposed its investors to higher risk than they would have probably assumed.

The care to take while adding debt funds to your portfolio

Debt funds can expose you to high investment risk if you do not select the scheme with eyes wide open. Along with credit risk, investors in debt funds are exposed to liquidity and interest rate risks. However, that does not mean you should avoid investing in debt funds altogether.

Though debt market conditions have improved, there are still challenges, especially for low-rated securities given the economic uncertainty and bleak outlook. Therefore, 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

In the current scenario, where interest rates seem almost bottomed out, you would do better going with low duration funds such as pure Liquid Fund and/or an Overnight Fund that does not have high exposure to private issuers.

This article first appeared on PersonalFN here

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