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Stock Analysis, IPO, Mutual Funds, Bonds & More

Have MF-corporate debt pacts left debt fund investors exposed?

Corporate bonds aggregate Rs 36.27 lakh crore, or about 28% of the total bond market.

Updated: Feb 20, 2019, 01.52 PM IST
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Prospects for debt mutual fund industry appears bright only if no major accident derails it.
Two of India’s celebrated billionaires — Zee’s Subhash Chandra and Reliance’s Anil Ambani — struggled to save their crumbling business empire this month. Thanks to lenders unlike Shylock, they have succeeded for now.

Those acts of benevolence from mutual funds would help Chandra and Ambani reorganise their debt-laden conglomerates, but they also raise questions about the risk assessment associated with such actions. The decision not to treat breach of covenants by Chandra and Ambani as credit events coming months after the implosion of Infrastructure Leasing & Financial Services (IL&FS) brings to focus the issue of liquidity and valuations risks in the Indian debt markets.

Despite efforts by the Securities & Exchange Board of India and the Reserve Bank of India, the debt market remains shallow exposing investors to losses beyond credit decisions. Mutual funds, which manage debt assets of Rs 11.48 lakh crore under liquid, income and bond funds, rely on the efficient functioning of market to fulfil their promise of redemption of units at the click of a button. But how much of help is market in times of stress? “The basic problem of the Indian market is that except for the large-cap stocks and liquid funds, there is no underlying liquidity for a majority of the investments,” says Dhirendra Kumar, founder, Value Research, an investment advisory. “That is the basic design of the market.”

Corporate bonds aggregate Rs 36.27 lakh crore, or about 28% of the total bond market. The trading ratio is less than 0.2%, i.e., the average trading volume to the total outstanding, data from Crisil Research shows.

VALUATION CHALLENGE
Marketable securities are the pillars on which the mutual fund edifice has been built with the promise of quick redemption. That would depend on the ability of the fund manager to sell a security without affecting the price much, or the impact cost.

The market depth could shrink dramatically when events like IL&FS default happens. That yields on triple A paper of mortgage lender DHFL shot up close to 200 basis points in a matter of hours, when DSP Mutual Fund wanted to sell, reflects the risks. One basis point is 0.01 percentage point. Given that most of the corporate bonds don’t even trade for days or some during their entire tenor, investors and funds are in danger of value erosion when there’s a rush out of the door.

“A lot of the fundamental liquidity issues in the domestic market have not been addressed,” says Jaideep Khanna, head of Asia Pacific at Barclays. “This mutual fund and NBFC crisis is a combination of a lack of risk management at the NBFCs, a lack of genuine diversification of papers that mutual funds held.”

Furthermore, the daily net asset value calculations, on which mutual funds sell and buy units, may turn out to be phony because there is no underlying transaction behind the assumed value.

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How do funds value their debt holdings in the absence of a market price? “There is a problem in the way bonds are valued,” says Ananth Narayan, professor of finance at SPJIMR, a Mumbai-based management institute. “Different funds value the same paper in different ways. It gets complicated once a company defaults because rating companies like Crisil and ICRA don’t provide any valuation.”

Even for interest-paying but thinly traded or untraded securities, valuation provided by rating companies is not absolutely transparent.

A poll is conducted among investors on what prices they would buy and sell, which becomes the benchmark to assign values. But there is conflict of interest in it given that those who hold such bonds are the ones who vote in the poll.

“Most of the insurance companies and mutual funds use benchmark spreads from rating agencies and at times there’s a big difference in the traded value and the benchmarks provided by these agencies,” says SP Prabhu, head, fixed income, IDBI Federal Life Insurance.

Other risks include bonds below 60-day maturity escaping the mark-to market norms and liquid funds holding 90-day paper for higher returns as asset management companies race to build up size.

CONCENTRATION RISK

The mutual fund industry has been the poster boy of the development of financial intermediation in India. It has grown more than five times in the past decade to Rs 22.85 lakh crore in assets from Rs 4.18 lakh crore in 2009.

Of this, fixed income funds comprising liquid, income, corporate and government bond fund assets are at Rs 11.48 lakh crore, or 50% of total assets. Growth in bond funds was due to it becoming more attractive than bank deposits and also due to convenience and efficient way to manage cash for corporates.

But a skewed investors’ profile worries some including regulators. “We don’t have enough diversification of investors at the short end of liquid funds and we do not have enough participants in the market,” says Khanna of Barclays.

While debt funds have more than 50% retail investors, who normally are not fair weather friends unlike corporate treasuries, in liquid and money market funds they are less than 5% with corporates at 70% raising risk.

Even the Reserve Bank of India flagged off the risk building up in the bond markets.

“The shift in credit intermediation from banks to non-banks has given the corporate sector a diverse choice of financing instruments,” said Governor Shaktikanta Das in the Financial Stability Report. “Such market-intermediated credit flows require robust supporting infrastructure in the form of appropriate valuation regime, as also informative and responsive credit rating framework.”

PERMANENT BAIL-OUTS
IL&FS’ decision to impose moratorium, mutual funds’ decision not to sell collateral provided by Zee’s Chandra and Reliance’s Ambani to secure their investors’ money despite covenants breach are leaving the lenders vulnerable if the borrowers’ positions turn worse.

Mutual funds’ decisions to defer the claims on the two may be justified if they repay, but what if their position worsens? Then the lenders’ ability to sell collateral would be more diminished than what it is today. In fact, a regulatory action may have sent signals to mutual funds that it is inclined more toward borrowers than investors. But Sebi recently came up with ‘side pocketing’, where mutual funds could carve out hard-to-value bonds in case of defaults and redeem those units after the resolution. That in a way is providing a permanent bailout mechanism like the US-64 and emboldens fund managers to take risks. “Side pocketing and other measures must be taken under extreme situations like the Lehman crisis or IL&FS situation,” says S Sriniwasan, managing director, Kotak Investment Advisors. “Other situations which are created through excessive risk taking are not fit for such concessions. The pricing of securities will now reflect decreased risk appetite which has already happened.” But some believe that it is aimed at protecting investors.

“I don’t think the introduction of side pocketing is bad as such because it protects investors and the market from excessive volatility. The basic rule of investing is no investor should benefit more or be hurt too much from the actions of the other investors.” The jury is out on fund managers’ conduct.

THE ROAD AHEAD

Irrespective of the conditions in the debt market, borrowers and investors would have little choice than lean on debt funds to plan retirement. The RBI’s mandate to big companies to reduce their dependence on banks to diversify risks makes the future for bond markets bright, only if some conditions change.

“The fundamental issue in the market today is that investor base is not broad enough,” says Rahul Goswami, CIO, fixed income, ICICI Prudential Mutual Fund. “And we need to broaden investor base starting from retail investors. People have to invest at FD rate by banks at 5%, when the similar maturity short term Treasury bill is offering 6%. So instead of talking about deepening the market, both the government and RBI can work on this basic fact.” While retail participation in debt markets is essential, it may be a long time before they jump in given the lack of research and advisory on bonds unlike stocks.

“We don’t have enough diversification of investors at the short end of liquid funds and we do not have enough participants in the market,” says Khanna of Barclays.

“We should make it easier for international investors to participate in trade. But on the flip side, we will be opening up to more risk, so we have to draw a balance.” Yet another critical institutional reform is to enable better liquidity facilities like repo under the RBI’s liquidity adjustment facility in highest-rated corporate bonds. “If the RBI Act is amended to accept triple A papers in repo, it would solve the vital issue of liquidity,” says Ananth Narayan of SPJIMR.

Yet another measure to safeguard investor interest is the mandatory liquidity measures till such time the depth in the markets improve. “A mandatory liquidity limit may also be considered by them,” says RBI in its latest Financial Stability Report.

Prospects for debt mutual fund industry appears bright only if no major accident derails it.
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