More safeguards for debt fund investors

SEBI places additional checks on debt fund investments

Following the recent instance of credit-quality downgrades and defaults in the bond market that hit debt fund investors heavily, the market regulator, SEBI (Securities and Exchange Board of India) has come out with a list of changes to make mutual funds investments safer.

Some key changes are explained below.

Change in valuation method

The SEBI has done away with the amortisation method of valuation in liquid funds while computing the NAV. Currently, debt securities in the portfolio of a liquid fund that have a maturity of up to 30 days are valued based on the amortisation method, while debt papers with a residual maturity of between 31 and 91 days are valued based on the marked-to-market method.

This implied less volatility in NAVs due to amortisation-based valuation for funds predominantly holding securities maturing in less than or equal to 30 days. But this also meant that the price assumed for NAV calculation may be far from the market price of the underlying security. Hence, in crisis situations such as the IL&FS/DHFL episode, the NAV could fall sharply.

Hence SEBI’s move to do away with the amortisation method of valuation will mitigate this risk, as NAVs will essentially reflect true portfolio values, in tandem with the market conditions. However, this would also imply that there will be increased volatility in returns.

More liquidity

The regulator has mandated liquid funds to hold at least 20 per cent in liquid assets such as cash, government securities, T-Bills and Repo on G-Secs. Usually, liquid funds hold 5-10 per cent collectively in these assets. They prefer commercial papers, NCDs (non-convertible debentures) with a residual maturity of below 91 days, and certificates of deposits, rather than G-Secs and T-Bills, as the former fetch higher yields. While this move will help liquid funds meet sudden redemption pressure, it may dim the returns.

Cut in sector limit

SEBI has cut liquid funds’ exposure to a single sector to 20 per cent, from 25 per cent earlier. The additional exposure to housing finance companies has also been reduced to 10 per cent, from 15 per cent.

This will help liquid funds curb concentration risk.

Currently (as of May 2019), 10-13 funds have more than 20 per cent exposure to sectors such as PSU/private banks and NBFCs.

Further, nine funds — including Mirae Asset Cash Management, BOI AXA Liquid and HSBC Cash — have more than 10 per cent allocation to housing finance companies.

Collateral cover

For any mutual fund scheme, exposure to debt instruments having credit enhancements has now been restricted to 10 per cent.

The regulator has further mandated that mutual funds should invest in those bonds which provide adequate security cover of at least four times the collateral. It is worth noting here that recently, a few mutual funds landed in trouble with the bonds issued by ADAG and Zee Group companies providing only 1.5-2 times the collateral support in the form of their equity shares.

When these bonds defaulted on payments, the mutual funds were unable to sell the collateral as the price of the shares fell below the collateral limit.

The new norms will ensure adequate collateral when required.

Unlisted equities, a no-no

Fresh investments in equity shares shall only be made in listed or to-be-listed equity shares.

According to data from NAVIndia, as of May 2019, mutual fund houses including Aditya Birla Sun Life, Sundaram, Taurus, Franklin, Kotak and Principal held around ₹84 crore in a few of unlisted equity shares issued by Chennai Super Kings, Brillo Technologies, Globsyn Technologies, IIFL Securities, IIFL Wealth Management and Numero Uno International.

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