An update on recent issues in Debt Fund

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What are the recent news and issues about Debt mutual funds?

The recent concerns are around the rating downgrades and possible or actual debt defaults that have occurred in some well-known and large corporates. A debt mutual fund is broadly subject to three levels of risks – Interest rate risk, Liquidity risk and Credit risk. Previously, interest rate / yield scenario kept investors on the edge. Credit Risk issues have kind of engulfed the debt fund universe in recent months.

What is a Credit event? In what ways this has this impacted the debt mutual funds and overall economy in general?  

With reference to the debt funds, Credit event refers to the downgrade in credit rating of debt or money market instruments, by a SEBI registered Credit Rating Agency as under –

  • Downgrade to ‘below investment grade’ or
  • Subsequent downgrades from ‘below investment grade’ or
  • Similar downgrades of a loan rating

Credit event is considered at the issuer level.

Rating downgrades generally impact the debt securities prices negatively and hence the return as well. Apart from this, a full-blown debt default event (also called the Credit Event) poses a bigger threat to the quality of investments itself. This is at the fund level.

Coming to the other part of the question, corporates borrow money for various activities. Debt Mutual funds invest in debt securities or instruments of various types and nature from different categories of issuers like government, private companies, etc. In a way MFs are lending to them. Lenders look at the rating and credit outlook, among other parameters before extending credit. Any rating downgrade impacts the company’s ability to raise funds for operating needs and/or expansion, etc. This, in turn, could affect the economic activity or contribution in a way.

Why there were steep single day fall in debt mutual fund NAVs?

Mutual fund NAV is per unit value of a scheme’s portfolio. The NAV of a MF Scheme (both equity and debt) moves up or down, depending on the valuation of the securities on any given day.

With respect to the steep fall witnessed by Debt Schemes recently on few days (example on 4th Jun ’19), it is because of the write-down on NAV of some debt securities rated below ‘Investment Grade’ held in the portfolio of certain schemes.

Little more in detail: In order to have uniformity and consistency on valuation of money market and debt securities rated below investment grade across the Mutual Fund industry, SEBI issued a circular in Mar’19, instructing AMCs to value such instruments at the price provided by AMFI appointed Valuation Agencies or on the basis of indicative haircuts provided by them (till such time the valuation agencies compute the valuation) during a credit event.

In essence, when there is a rating downgrade (credit event), MFs owning those debt securities have to mark-down the value of those securities as per the valuation norms, irrespective of whether it results in actual default or not. The prescribed indicative haircuts range from 15% to 100% for a Senior / Secured debt instrument to 25% to 100% for a Subordinated / Unsecured debt instrument, depending on the industry type and Rating.

 Like steep fall, can the NAV move up faster too?

Yes, it’s possible. When the scheme receives the defaulted money from the affected security (issuer) or when the rating upgrade happens, the prices and valuations can jump and hence the NAV. Considering this example: Rating agencies downgraded commercial papers of an entity at the start of Jun’19 to ‘below investment grade’ and hence MFs took a hit of 100% mark down on the value of some of the securities. By end of Jun’19 the issuer made part payment of approx. 40% of the aggregate due amount. Schemes holding those securities witnessed jump in NAV to that extent of payment, proportionate to the weight it had on the total NAV/AUM.

What is a Segregated Portfolio?

Segregation of portfolio refers to the process of separating the ‘credit event’ affected securities from the total portfolio. It is also called as ‘Side-Pocketing’. It distinguishes the scheme portfolio and NAV into ‘Main’ and ‘Segregated’ portfolio.

  • Main portfolio contains securities that are liquid and unaffected by any credit event and would continue to transact like a normal one.
  • Segregated Portfolio (Side-pocketed) contains only those securities affected by credit event. No fresh investments or redemption is permitted in segregated portfolio. Only recovery would be distributed to the existing investors, as and when it happens, either full or partial as the case may be.
  • Main + Segregated portfolio is called as ‘Total Portfolio’.

SEBI issued a circular regarding creation of Segregated Portfolio in Dec 2018 including the process, valuation, disclosure and monitoring requirements.

What is the process of creation of segregated portfolio?

Following are the broad key points about creation of segregated portfolio:

  • Creation of segregated portfolio is at the discretion of an AMC.
  • It can be created only when a scheme’s SID (scheme information document) contains provisions to do so.
  • AMC after deciding on creating segregated portfolio, shall seek approval from broad of trustees.
  • Immediately issue a press release, display the same prominently in its website.
  • Till the time trustee approval is received (Max. 1 business day from credit event), subscription and redemption in the scheme shall be suspended.

Post receiving Trustee approval:

  • 2 portfolios would be created: Main and Segregated portfolio.
  • All existing investors as of day of credit event would be allotted equal number of units in segregated portfolio as held in the Main portfolio.
  • 2 separate NAVs would be displayed – one of the Main portfolio and another one of Segregated portfolio and both shall be disclosed daily.
  • Main portfolio would continue to function like a normal scheme.
  • No redemption and subscription shall be allowed in the segregated portfolio
  • However, in order to facilitate exit to unit holders in Segregated portfolio, AMC shall enable listing of units of segregated portfolio on the recognized stock exchange within 10 working days of creation of Segregated portfolio and also enable transfer of such units on receipt of transfer requests.
  • AMCs shall issue a press release and have to communicate the unit holders through an e-mail or SMS.

Apart from this there are detailed valuation, disclosure and monitoring by trustee norms prescribed by SEBI in the circular.

Some debt funds are resorting to creation of Segregated Portfolio (side-pocketing). Will this help investors?

As explained above, segregation of portfolio is to distinguish between the quality papers from others in a mutual fund scheme, in case of a credit event. Theoretically it is fair for 2 reasons.

  1. During the times of Rating downgrade or Default, affected instrument becomes illiquid in the secondary market. If investors rush for mass redemption due to panic, fund manager would be forced to sell other good or quality papers to meet the redemption pressure, to the extent possible. Then, what the portfolio would be left with would be the illiquid / low quality securities. It affects all.
  2. To avoid speculative entry post crisis or unfair ‘profiteering’ move by some investors, who might want to gain from windfall in case of recovery of any sorts (due to better rating or honoring of payments, etc of the affected securities). This would also affect the rightful gain of existing investors, who had been through the pain and dust.
How many AMCs have announced the creation of Segregated portfolio?

Post SEBI circular on Portfolio Segregation, Tata MF is the first AMC to implement this in an open-ended Debt fund in three of their schemes. As of 14-Aug-2019, we noticed 10 AMCs having issued notice on proposed changes to the Scheme information document for including provisions for creation of segregated portfolio.

 What are the mistakes an investor can avoid while investing in debt mutual funds under current scenario?

Investing without awareness and understanding is the biggest mistake anyone would commit and should be watchful not to do that. Investors should be aware of the inherent risks and nature of the product before committing the investments. Debt MF offers advantages over other traditional fixed income products, but they also come with Market, Interest rate, Liquidity and Credit risks. It is not necessary that all the risks will attack at the same time or one at a time. There’s nothing like that. It is the individual’s outlook on an attribute. Also allocation should be strictly as per the risk profile. One should avoid over-exposing to a particular type of investment product.

As far the debt scheme is concerned the primary factors one should consider are, the credit quality of the portfolio – how much of it is in AAA rated and below, the average maturity and the modified duration – which essentially indicates the degree of fluctuations in case of interest rate changes, the concentration level – how much % weight the top holdings / sectors carry, the scheme’s, fund manager’s track record and the risk management processes adopted by the fund house could be checked upon.

What are the regulatory developments around these?

SEBI has been continuously monitoring the investment management space and has come up with relevant rules and guidelines from time to time. Sometimes it serves as a pre-cautionary step. But sometimes, the risk events itself are evolving. During those times, it requires to study and approach it suitably with certain degree of multi-scopic view, which they are doing to a great extent. In the backdrop of ongoing credit issues, SEBI had earlier constituted working groups for brainstorming various possible means through which the investment and risk management in mutual funds could be strengthened. Accordingly in Jun’19 a slew of norms and measures, which are expected to bring in higher safety and transparency were announced. That includes Valuation norms, Investment norms to maintain and meet liquidity needs, prudential limits on sector exposure, instrument types and group level limits and caps and adequate security cover in case of corporate lending.

SEBI said that the above measures were taken in the context of recent issues and concerns around the promoter/ companies raising funds from Mutual Funds/ NBFCs through structured obligations, pledge of shares, non-disposal undertakings, corporate/ promoter guarantees and various other complex structures (referring to cases like Essel group).

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