Sebi trying to change rules of the game in debt funds, and how!

NEW DELHI: Even though debt mutual funds have stabilised and the redemption pressure seen in April-May has eased substantially, liquidity remains constrained, especially in sub-AAA papers.

Ajay Tyagi, Chairman of Sebi (Securities and Exchange Board of India), on Tuesday said the market regulator would soon take certain measures to prepare the industry for crisis like these and address the illiquidity issues.

He said the steps would include setting up of an expert committee to frame a stress-testing methodology and design a framework to determine the minimum liquid asset required in debt fund schemes; establishing a clearing corporation and setting up a backstop facility that can absorb illiquid papers at the time of crisis.

“Definitely, they would help the debt mutual fund market. No fund wants a buildup of illiquid instruments, but [currently] they don’t even realise when an instrument turns illiquid. This kind of stress test will help funds prepare for worst-case scenarios, and it will bring out the weaknesses in the system,” said Vidya Bala, Co-founder of mutual fund research firm PrimeInvestor.in.

The Chennai-based analyst said these measures would make the debt market more vibrant, as investor confidence in sub-AAA rated papers will increase as they will be better aware of the risks.

The steps are still in the deliberation phase, and Sebi is yet to decide the timeline and nature of institutions that will be established. But industry watchers agree the measures sound promising.

ETMarkets did the legwork to understand what these steps mean for the industry and how they could assuage investor concerns. The answers we found are largely based on discussions with Parijat Agrawal, Head of Fixed Income, Union AMC, which is an arm of Union Bank of India. Read on...

What is this expert committee supposed to do?
Sebi said it is facilitating the setting up of an expert committee to, one, design a framework to determine the minimum liquid asset required in these schemes and, two, to frame a stress-testing methodology encompassing liquidity, credit and market risk for debt schemes.

Let’s understand the first mandate of the committee. Apart from liquid funds, which are mandated to hold 20 per cent of their AUMs in liquid assets like cash and G-Sec, other funds have no such requirement, which makes them susceptible to closure if there is heavy redemption pressure, something which happened with Franklin Templeton’s funds in April.

Following that episode, on requests of the asset management companies, Sebi had given a temporary approval to allow government securities (which are highly liquid and can be converted into cash anytime) in core asset allocation of credit risk funds, corporate debt funds and banking and PSU debt funds to meet heightened redemption requests. Now, expert panel will look for a permanent solution to the problem.

In the meantime, taking into account the recommendations made by the Mutual Fund Advisory Committee, Sebi has said it would be stipulating a minimum holding of liquid assets by all debt-oriented schemes.

What is the other mandate of this committee about? What does that mean?
The second mandate relates to framing of norms for stress-tests on fund schemes. In simple words, this means creating the worst-case scenario and putting fund schemes through that test, which will prepare them for the real thing. Any strain in the economy, interest rates moving too high (something that happened in 2013 that resulted in negative returns for liquid funds for the first time), the probability that some companies might default, selling pressure due to substantial redemption pressure – these are some of the scenarios that can be used.

The test will gauge how much of an impact such changes in rates, credit and liquidity will have on a fund portfolio. Sebi guidelines require liquid funds to do this already.

Do mutual funds have no such measures in place for all schemes?
Many fund houses claim they have risk assessment teams, which have internal mechanisms to run stress tests on their schemes. However, Sebi has not made it mandatory. So, it is up to the asset management companies to put such systems in place.

The expert committee will likely frame uniform rules and models that will be used by all mutual fund houses.

Why is Sebi establishing a clearing corporation?
Sebi is pursuing this measure to increase liquidity in the secondary market and also enable greater issuances of paper rated below AAA, largely bu having a liquid repo market. To facilitate this, Sebi will establish a limited purpose central clearing corporation for guaranteed settlement of tri-party repo trades in all investment grade corporate bonds, including those rated below AAA, to boost repo trading in corporate bonds.

Wait! What is repo trading?
Short answer: This is lending and borrowing using debt papers, as collateral.
Long answer: In a repo or repurchase agreement, one party sells an instrument to another party at a price and commits to repurchase it at a higher price (price difference becoming the interest) on a future date. If the seller defaults during the life of the repo, the buyer can sell the asset to a third party to offset the loss. The asset, therefore, acts as collateral and mitigates the credit risk that the buyer has on the seller.

For example, a fund scheme may suddenly need emergency funds to meet redemption pressure, but is unable to sell instruments due to illiquidity. If there is a liquid repo market, the fund manager can have access to low-cost funds collateralised by papers she holds.

In India, the repo market on corporate bonds has unfortunately not taken off till now. Sebi believes having a mechanism for guaranteed settlement of the agreement create bring volume in repo trading.

What is that backstop facility?
When a fund sees heavy redemption pressure and the market turns illiquid, selling a debt paper is a difficult task, because a buyer will not be available because of risk aversion (the reason that led to closure of funds by Franklin Templeton). So, this backstop facility will be an entity which will buy those instruments even when there are no buyers available. Later, that entity will offload those papers once the situation normalises.
Sebi believes this will instill greater confidence among market participants in corporate bonds, especially in below-AAA investment grade bonds.

What does all this mean for a common investor?
The market regulator and the mutual fund industry believe these moves will increase confidence in debt funds, which have been shaken up since the Franklin Templeton episode.

So, for example if you are invested in a credit risk fund, your money will not be blocked because the fund cannot sell the debt papers or has depleted all the cash or cash-like holdings.

Remember, everything is just an idea at this stage. It remains to be seen how efficient and successful these institutions and measures will be for the industry.