The Securities Exchange Board of India (SEBI) has been implementing a slew of reforms time and again to safeguard the interest of retail investors. Swing pricing guidelines applicable to debt mutual funds is the latest among others.

From March 2022 onwards, certain open-ended debt funds schemes will have to follow a ‘swing pricing‘ framework. SEBI has excluded overnight funds, gilt funds, and gilt with 10-year maturity funds from the purview of swing pricing.

While many investors realise that even the best equity mutual fund scheme carries high risk, some investors usually fail to recognize the risks associated with debt funds.

Investing in debt funds isn’t risk-free. Unfortunately, Indian investors have learned this lesson a hard way after the IL&FS and DHFL fiasco, which demonstrated how vulnerable the small debt fund investors are.

At PersonalFN, we have covered these stories extensively along with all subsequent developments. But I would like to recap some specific points pertaining to the DHFL defaults. This might help you better understand the significance of swing pricing reforms from SEBI.

If you remember, DSP Mutual Fund sold DHFL’s ‘AAA’ rated Non-Convertible Debentures (NCDs) of Rs 300 crore at a yield of 11% in September 2018. As you would know, the higher the yields, the lower are the bond prices and vice-versa. Therefore, the yield of 11% on an ‘AAA’ rated paper was too high by any assessment.

Later, the fund house clarified that the deal preceding the DSP Mutual Fund’s deal happened in the yield range of 10.25%-10.50%. But considering a sudden jump in volumes on account of the sales transaction of DSP Mutual Fund on a single day, the yields jumped to 11%.

DSP Mutual Fund also stated that it was more a call on interest rate risk mitigation than credit risk management. In other words, the fund house was worried about bond prices falling on account of a potential rise in the interest rates rather than any potential default by DHFL.

To pacify the debt markets worried by its move, the fund house stated that it continued to hold Rs 800-crore position in the DHFL’s debt. But the damage was already done. Within 8-9 months since then, independent credit rating agencies downgraded DHFL to ‘D’-an event that caught many mutual fund schemes napping.

This brings me to another important point that I want to make here. Large institutional investors are well-informed as compared to small retail investors. Thus, many retail investors tend to follow their decisions in the cases of market dislocations. And sudden redemptions following such events often have spiralling effects.

Moreover, except for the sovereign securities (G-sec) market, India’s secondary bond market is relatively not so liquid. Thus, it struggles to absorb these sudden shocks, thereby making it tough for debt fund managers to deal with liquidity crunch and challenging market conditions.

And that’s where swing pricing will help in my view.

Let’s first look at what the swing pricing is…

In simple words, swing pricing denotes the cost-adjusted Net Asset Value (NAV) of a debt mutual fund scheme.

If a debt mutual fund scheme witnesses sudden capital outflows due to high-value redemptions (like the DHFL-style fiasco), it causes damage to the interest of continuing investors, particularly the small retail investors. Swing pricing ensures that the exiting investors, i.e. the ones redeeming high-value investments pay for it.

Swing pricing comes in two forms-partial swing pricing and full swing pricing. Under partial swing pricing mechanism, swing factor and swing threshold are well-defined or at least their range is defined. As and when the limits are triggered, the swing pricing mechanism comes into play.

Under full swing pricing, all redemptions/new purchases, even when the thresholds aren’t triggered, are made at swung NAVs.

To begin with, SEBI has rolled out a scenario-based hybrid framework of swing pricing. To be more specific, only outflow scenarios will be covered; and under normal market conditions, partial swing pricing will be applicable. And during market dislocations, a full swing mechanism shall be exercised. SEBI will either take a suo moto decision on what qualifies for market dislocation or take on the Association of Mutual Funds in India’s (AMFI’s) recommendations.

While SEBI has prescribed the minimum swing factors, the thresholds of triggering them will be prescribed by the AMFI. It will also suggest the indicative range of the swing threshold.

AMFI is expected to suggest broad parameters for swing pricing by the end of December 2021.

Under normal circumstances, AMCs (Asset Management Companies) can determine whether the swing pricing will be applicable and may choose the quantum of the swing factor, depending on scheme-specific characteristics and keeping in mind overall guidelines in this regard. Moreover, AMCs can have additional parameters over and above those suggested by AMFI. It will be mandatory on the part of the AMC to disclose all of this in its Scheme Information Document.

Table: Minimum swing factor for open-ended debt funds

Interest rate risk category Credit risk category
Class A (CRV>=12) Class A (CRV>=10) Class C (CRV<10)
Class I (MD<=1 Year) Optional Optional 1.50%
Class II (MD<=3 Year) Optional 1.25% 1.75%
Class III ( Any other MD) 1.00% 1.50% 2.00%

MD: Macaulay Duration
CRV: Credit Risk Value
(Source: SEBI

It appears that debt schemes with lower interest rate sensitivity and superior credit profiles will be least affected by swing pricing. However, swing pricing will be more relevant to several high and ultra-high risk categories such as credit risk funds, especially those with longer maturities. Let’s understand how the swing pricing may actually work:

If a debt scheme defines the swing factor as 2% and the swing threshold as 10%, (after following requisite rules stipulated by SEBI and potential thresholds prescribed by AMFI), a 10% outflow would see a 2% downward adjustment in NAV.

For instance, a debt fund with a net capital position of Rs 5,000 crore quoting at a NAV of Rs 350 witnesses a net outflow of Rs 550 crore on account of high redemption pressure. In this case, the NAV will be adjusted to Rs 343; 2% lower. Such practice will make investors responsible for large swings in the AUM, on account of sudden inflows/outflows. This swung NAV will apply to all incoming investors in such scenarios, to be fair with them.

Keep in mind, the incorporation of swing factors mentioned in Table 1 and the Scheme Information Document by the existing open-ended debt schemes will not be treated as a change in the fundamental attribute. However, any change beyond that prescribed in Table 1 or pertaining to optional swing pricing would be fundamental in nature.

And to calculate debt mutual fund scheme performance, the AMC will have to consider un-swung NAV.

What are the potential benefits of swing pricing?

  1. It would curb the opportunistic behaviour of well-informed large investors by taking away their first-mover advantage. It can hold them accountable for their actions.
  2. Make large investors pay for the consequences of sudden outflows on other investors who stay invested thereby protecting small debt fund investors.
  3. Help fund managers deal with redemption pressure more effectively under a distressed liquidity scenario.
  4. Curb panic redemptions under challenging liquidity conditions and during times of market dislocations.

Moreover, SEBI has asked all AMCs (Asset Management Companies) to provide adequate disclosures along with illustrations in the SID. Swing pricing will be made applicable to all unitholders at the PAN level with an exemption for redemption up to Rs 2 lakh for each mutual fund scheme for both normal times and market dislocation.

Clearly, the implementation of a swing pricing framework will help protect the interest of small debt fund investors.

This article first appeared on PersonalFN here

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