How to avoid future blowups in fixed income funds?

Nishant is associated with capital markets since 2005. In his recent role, he is managing the portfolio of an HNI as an employee. Nishant is an aspiring fee-only financial planner who intends to start an affordable fee-only advisory after getting the licence from SEBI.

Opinions expressed are the authors and should not be construed as investment advice from Kuvera.

 

Four Big Pillars of Mutual Fund Industry can play a better role in avoiding one more serialized catastrophic turn of events in Fixed Income Space

 

Mutual Fund industry has four main participants:

  1. The Regulator (Securities and Exchange Board of India)
  2. The Manufacturer (Asset Management Companies)
  3. The Allocator (Adviser or Distributor)
  4. The Unitholder (Investor)

One crisis after the another has changed the landscape of debt mutual funds & it has highlighted all the flaws in the approach adopted by these four pillars. In the last 20 months, debt mutual funds have gone through a roller coaster ride − Downgrades, Defaults, Segregations, close-ended structures unable to meet complete redemption on the maturity date, rollover of close-ended schemes, AMC taking the exposure on its book, AT-1 Bonds being written down to zero & a multinational AMC shutting down six of its schemes. Let’s take a small recap of these events.

It all started with the default of Infrastructure Leasing & Financial Services (IL&FS), signs of trouble emerged in June’2018 when behemoth financial conglomerate defaulted on inter-corporate deposits and commercial papers (borrowings) worth about Rs 450 crore. The rating was finally downgraded to “D” in September’2018. Although Credit Rating Agencies is not the topic for this article still I would like to highlight, Grant Thornton during their forensic audit observed communications between rating agencies and IL&FS group officials in which rating agencies had concerns as early as 2012 but the ratings assigned to IL&FS firms remained high until middle of 2018. The whole financial services industry runs on trust and confidence and any rumour can bring the confidence crashing down. In September’2018, decades-old housing finance company began its downhill journey triggered by IL&FS default and panic sell of its debentures worth 300 crore by one Asset Management Company at a higher yield. Asset Liability Management was no more a jargon. About a quarter of the DHFL’s loan book was wholesale. DHFL was rated AAA till Feb’2019 and on 05th June’2019, credit rating agency downgraded it to DEFAULT. With the default of DHFL, three schemes of TATA AMC became the first adopters of side pocketing provisions introduced by the regulator in December’2018. About 87000 bondholders are also struck holding DHFL bonds directly. As the DHFL saga was taking place, another storm was brewing up for Mutual Fund industry when lenders of Essel Group agreed for a standstill agreement for eight months till 30th September’2019. One particular AMC withhold certain part of units on maturity of certain Fixed Maturity Plans whereas another one tried to rollover the Fixed Maturity Plans having exposure of Essel Group. Both of these AMCs were sent show cause notices from the regulator challenging the legal standing of standstill agreement with the Essel Group. In March’2020 one of the AMC was slapped with fine of around 4.2 crore in relation to this case. On 17th June’2019, HDFC AMC informed the exchanges about the liquidity arrangement for struck FMP investors and AMC took the exposure of approx. 500 crore on their own book. HDFC AMC has also booked revaluation mark to market loss of more than 150 Crore and is most probably holding this exposure till date.

List of all defaults, from September’2018 to March’2020 have been shared in figure below, final one being Yes Bank. In Financial Year 2019-2020, Credit Rating Agency ICRA downgraded the ratings of 584 entities, downgrade rate of 16% vs the past five-year average of 9%. Yes Bank was placed under a moratorium on 05th March’2020 and on 06th March’2020 RBI shared the scheme of reconstruction in the public domain. As per the draft release “scheme of reconstruction” by the central bank, the instruments qualifying as Additional Tier 1 capital, issued by the Yes Bank under Basel III framework, shall stand written down permanently, in full. One of the fund houses through its debenture trustee filed the petition in Bombay High Court against the RBI, Government of India and Yes Bank.

Franklin declared its month end portfolio for March’2020, five of the six schemes which were winded up had negative cash balance. These schemes experienced unprecedented redemption pressure in the month of March and April. Regulator granted special permission for enhanced borrowing for up to 30% in two of the schemes and 40% in one of the schemes. Ultimately the fund house took the decision to wind up the schemes. Remarks from their Global CEO, SEBI response to it, AMCs unconditional apology, cases in different courts, immunity for trustees, shifting of all cases to Karnataka High Court and the story continues.

Let’s discuss the role these four participants can play in avoiding one more serialized catastrophic turn of events in Fixed Income space:

The Regulator (SEBI)

Structure of debt funds

open ended structure for debt schemes, especially those schemes which are investing in corporate bonds, offer immediate (T+1) liquidity to unitholders although the papers in which they invest in are not that liquid and are at the mercy of market environment. As Mutual Funds are pass through vehicles, redemption requests are either honored by selling the assets the scheme holds or by borrowing against those assets. Sudden rise in redemptions (greater than the liquid portion of the portfolio) can lead to more panic and more redemptions. Scheme will keep selling the liquid marketable assets and sleeping unitholders will be left with higher proportion of lower rated papers. Regulator must take immediate action and limit the lower ended corporate bond exposures to close-ended or interval funds only.

Re-categorization 2.0

Re-categorization 1.0 has its own merits, it makes the schemes comparable across categories and also defined the definition of large cap, mid cap and small cap stocks. It also clears a lot of confusion for investors by eliminating multiple schemes from same category (open ended schemes only) from the same asset management company. In the fixed income space there are 16 categories and different fund houses are positioned differently in most of these 16 categories and it becomes very difficult of investors to understand the intricacies of different strategies adopted by different fund houses. Consider this dynamic bond category: here my guess is this category is created by the regulator to give fund managers the flexibility to generate returns by taking active duration calls, but due to no credit band, one of the AMC ended up in running it like a pure credit risk fund (scheme name: Franklin India Dynamic Accrual Fund), one fund house took concentrated credit calls in this category (Aditya Birla Sun Life Dynamic Bond Fund) and one fund house is now running 10 year roll down strategy in this category (Nippon India Dynamic Bond Fund). I love roll down strategies but there should be a separate category for running roll down strategies with strict credit bands and with no restriction on number of schemes in this category, this can be named as Target Maturity Funds. The number of categories in open ended debt space can also be brought down starting from moving credit risk fund to close ended/interval structure.

In Re-categorization 1.0, the regulator missed to define the mandate of debt allocation and equity allocation in hybrid schemes, same can also be defined in new edition.

Regulator must also bridge the gap by which Franklin Templeton was able to fit in long dated debentures in ultra-short duration fund. Riskometer also needs to be looked in as Dynamic Asset Allocation Funds cannot have the same risk as small cap funds.

20-25 Rule

As per the regulations, a mutual fund scheme shall have a minimum of 20 investors and no single investor shall account for more than 25% of the corpus of the Scheme. Regulator can re-examine this rule and restrict the maximum single investor exposure to 5% in scheme exposed to corporate credit. Logically as well, this should not be more than the borrowing limit. Larger outflows can increase the allocation of bad assets in the portfolio.

Regulator can also limit the % of AUM controlled by single distributor  in a particular scheme.

Borrowing Limits:

The regulation allows schemes to borrow funds up to 20% of the AUM to meet redemption requirements. Franklin Templeton, before winding up the six of its schemes, approached the regulator for increase in the borrowing limits and regulator made a mistake (the cost of which will be borne by remaining unitholders) by allowing it to borrow up to 30% for a couple of schemes and up to 40% of the AUM in one scheme. Regulator must bring this limit down and bring regulations similar to Statutory Liquidity Ratio under which funds exposed to corporate credit can be mandated to maintain a defined pie of their assets in sovereign securities (T-Bills, SDLs, GoI bonds). Even if current regime continues regulator must now allow the AMCs for granting permissions of excessive borrowings as it can severely hurt the unitholders who are left behind.

Rationalization of taxation for Alternate Investment Fund II

Taxation of AIFs is way more complex than mutual funds. Mutual Funds income is either taxed as capital gain (short term as well as long term, depending on the holding period of unitholder and not the underlying asset) or dividend income (actual dividend income received by the unit holder, at marginal rate of taxation) and higher-income unitholders can choose growth option for tax optimization. On the other hand, AIFs are taxed differently depending on the category of AIF, for the context of this debate our discussion is limited to AIF II, as a debt fund can be formed in this category only. Although, just like mutual funds, AIF II have pass-through status but i.e. Fund (Mutual Funds or AIF) have no tax liability, tax liability is transferred to unitholders/investor. AIF investors are charged differently for interest income (at marginal rate of taxation) and differently for capital gains (at 10% or 15%, plus cess and surcharge, depending on the holding period of underlying asset). Here the key difference is, Mutual Funds are taxed on holding period of units by the unitholder whereas AIF investor is taxed on the holding period of underlying asset and not the holding period of units by the investor. This tax disadvantage has not allowed the development of AIFs. The development of AIF in credit space is important for the overall development of debt markets in India as AIF can raise money from Accredited Investors like UHNIs, Family offices, foreign investors. Regulator can approach appropriate authorities for rationalization of taxes and provide level playing field.

Perpetual Bonds

SEBI must classify this quasi equity instrument as equity and preclude the same from fixed income basket. Apart from standard single issuer and group limits, there are no regulatory restrictions for buying AT-1 bonds. Insurance Regulatory and Development Authority of India (IRDA) classify it as
equity investment.

Valuation by Rating agencies and actual traded price

Debt & Money Market securities are currently valued at the mean prices provided by AMFI approved agencies (currently CRISIL and ICRA). In case of price is available from only one agency, the same is considered for valuation. This process is fair till the time securities are restricted to Treasury Bills, GoI Bonds and State Development Loans but complication starts when the same is applied on Commercial Papers and Corporate Bonds and securities suffixed by SO (Structured Obligation) or CE (Credit Enhancement). The debt market in India is shallow (specially for lower rated corporate bonds) and there can be a mismatch in the valuations provided by Credit Rating Agencies and the actual price a buyer is willing to pay to buy these papers. Calculation of NAV for illiquid bonds are done on the basis of valuation provided by rating agencies. The difference between the availability of information for retail investor and Accredited Investors is huge and regulator can reintroduce retail plans with exposure limited to only Treasury Bills and Sovereign credit. Regulator can lower the fund formation and related expenses for this category, forbid inter scheme transfers in this category and cap per PAN exposure in the scheme.

Enhanced qualification & experience requirements

Regulator can raise the bar for qualification and experience requirements for selling and distributing mutual funds (Individual Mutual Fund Distributors, Employees of organizations engaged in sales and distribution of Mutual Funds & Employees of Asset Management Companies specially persons engaged in sales and distribution of Mutual Funds). Currently any 18-year-old person who has passes 12th Class and has a Permanent Account Number can become a mutual fund distributor by passing a simple exam “NISM-Series-V-A: Mutual Fund Distributors Certification Examination”. One has to score 50% marks in a multiple-choice question format with no negative marking. There is no minimum experience required o become a mutual fund distributor.

The eligibility criteria for become a Registered Investment Advisor include, passing two exams namely “NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination” & “NISM-Series-X-B: Investment Adviser (Level 2) Certification Examination” (passing score 60% with negative marking) and having a minimum of 3 years of experience and post-graduation or professional qualification. Regulator can bring those two things at par as both the professions manage their client’s money.

The Manufacturer (Asset Management Companies)

Illusionary liquidity

Some of the Asset Management Companies were under the illusion that diversified investor base and levying loads can ensure liquidity. AMCs forgot that even with the diversified investor base, AUM is controlled by few large distributors and mass redemptions can only be honored if the underlying assets are liquid. When panic strikes, unitholders don’t bother about exit loads and fund houses can see a large part of the portfolio getting redeemed within a very short span of time. In open ended debt funds, where funds have no restrictions to come in or go out, it’s the underlying asset which gives liquidity and not the diversified investor base or load structures. Below are the figures for ICICI Prudential Credit Risk Fund, figure 1 has month end AUM from September’2018 and figure 2 has daily AUM from 01st March’2020. Figure 3 has list of defaulted papers which AMC was able to tide over with zero exposure (even a decently performing fund can see mass redemptions). Redemption on 28th April’2020 was almost 12% of the net assets of the scheme on 27th April’2020. The AUM has fallen from the peak of 12928 crore on 06th March to 6575 Crore on 12th June’2020, a fall of 49% from peak within 100 calendar days.

Chasing the AUM

Asset Management Companies are aware of the behavioral biases of the investors. They know higher AUM will get attracted with higher returns and to generate higher returns AMCs increases the risk in the portfolio. I understand the competitive nature of industry and management’s responsibility towards their shareholders and at the same time Asset Management Companies must educate the masses about cyclicality of performance, just a mere disclaimer that past performance is not indicative of future returns is not enough. Fund Manager’s bonus and appraisal should be based on how the fund manager has navigated in tough times and not on the basis of quantum of AUM gathered.

Risk Management

Asset Management Companies must have segregation of risk management and investment function. Credit evaluation cannot be done by investment team and underwriting team must have independence in taking calls. Asset Management Companies should not follow the regulatory limits of issuer (10%) and group (20%) exposure on boundary line. In the Essel FMP saga, exposure to schemes were as high as 20%. AMCs should also manage the concentration on liability side and put a cap on single investor investment in scheme. AMC can also disincentivise their distributors with lower commissions on incremental flows after the distributors have reached a particular threshold in term of percentage of AUM in the scheme. AMCs must also understand that collateral cannot be the basic thesis of investment and should not underwrite to companies with no cash flow by mortgaging promoter holdings. Although the regulator in its Press Release PR No.16/2019 have defined the adequate security cover of at least 4 times for investment by Mutual Fund schemes in debt securities having credit enhancements backed by equities directly or indirectly.

Creation and promotion of core bucket products

The Asset Management Company should create and promote more and more core bucket products. The insatiate desire to offer higher YTMs is perilous for unitholders as well as the long-term reputation of AMC. Millennial who have just started financialization of their savings and opted Mutual Funds as their investment vehicle must get good experience and should be discourage to invest in satellite products with higher credit or interest rate risk. More and more target maturity structures should be created and portfolios should be restricted to T-Bills, Government Bonds, State Development Loans and super AAA issuers.

Side Pocketing

Side pocketing provisions were introduced by the regulator in December’2018. Even till date, all the AMCs have not made appropriate amendment in Scheme Information Document to incorporate provisions of segregated portfolios in the scheme. Creation of segregated portfolio helps ensuring fair treatment to all unitholders in case of a credit event (downgrade below investment grade or actual default) and helps in managing liquidity risk during such events. A lot of schemes are carrying NCDs at zero value in their main portfolio just because these AMCs have not timely incorporated the appropriate amendments in their schemes. Just before recovery in these zero cost NCDs, smart money will come in and swell the AUM of the scheme and dilute the gains.

Skin in the game:

Currently the sponsor or AMC is required to invest 1% of the AUM gathered in NFO or ₹ 50,00,000 which ever is smaller. AMCs, Fund Management Team and other employees shall eat the same food which they serve and should demonstrate conviction and confidence in their fund management skills. ICICI Prudential AMC invested ₹ 334 Crore (₹ 78 crore in October’2019 and ₹ 256 Crore in December’2019) in own credit risk fund & it has navigated the crises exceptionally well.

The Allocator (Adviser or Distributor)

Forward Looking

Past performance is one of the indicators to access the performance of a scheme or fund manager but it is not the sole criteria. It is easier for an advisor/distributor to sell recent performance but at the same time advisors/distributors should keep in mind that strategies and/or asset classes perform in cycles. Advise should be forward looking and not based on recent performance. For example, credit risk funds have been sold to investors just on the basis of past returns.

Suitability

Recommendations should be based on the risk profile, investment horizon, objective of the investment and overall place of the recommended instrument in portfolio of the investor. Advisors/Distributors should not sell/recommend unfitting products to the investors. There had been instances where balanced funds have been sold to retirees as a replacement of fixed deposits, solely based on dividend pay-outs and overlooking the risk involved with the instrument. In fixed income space, various reports are doing the round on how relationship managers at Yes Bank has sold AT-1 bonds to retail individual investors. Investor should be advised for schemes like PPF, EPF/VPF, Sukanya Samridhi Scheme and NPS for their long-term goals.

Fear Basket = Fixed Income

Fixed Income will never provide multibagger returns, returns on the upside are capped and there is no floor on the downside i.e an individual corporate bond can go to zero, just like yes bank AT1 perpetual bond. Investor should allocate a decent portion of fixed income allocation in core schemes and only a small tactical allocation can be taken in funds with higher interest rate risk or credit risk. Avoid any kind of adventures in this asset class.

Risk Management

Advisers can check single issuer (non-sovereign) and group level concentration in the scheme recommended. Similarly, scheme should be diversified across sectors and any sector concentration can be seen as red flag in fixed income space. Advisers can also deep dive and check for details of underlying holdings, details like secured or unsecured, guaranteed or not guaranteed and outlook of credit rating agencies (positive, neutral or negative). Advisers should also keep in mind interest rate sensitivity of the scheme. Roll down maturities or target maturity ETFs should be preferred and aligned to investor’s goal.

Return Expectation

Advisors and Distributors should tone down the high return expectations of investors. Higher return expectation investors will be inclined towards taking more risk and may not have good investment experience. Fixed income return expectations can’t be significantly more than what 10-year government bond is offering. In equity it’s the combination of real GDP Growth, inflation and equity risk premium.

The Unitholder (Investor)

Don’t reach for yield

More money has been lost reaching for yield than at the point of a gun − Raymond DeVoe Jr

Look at the table below, some of those who chased yields are watching the development of Franklin fiasco. Whenever a mutual fund offers extra yield, look for the reasons and you will be able to spot the wolf in sheep’s clothing.

Diversification

Diversifying the investments across different asset classes is the time-tested method to mitigate risks. As per the risk profile and goals, investments should be diversified across fixed income (through mutual funds, bank deposits, PPF, EPF, etc), equity (mutual funds and NPS), Gold (Sovereign Gold Bond, Digital Gold, Gold ETFs, physical gold) and global equities (through mutual funds or LRS Scheme if investments amounts are significant).

 Goal-Based Investment:

Unitholders must stick to goal-based financial planning and should not do random or transaction-based investments. Randomly taking investment decisions is like randomly taking medicines or nutrients. The process should be based on asset allocation and portfolio should be re-balanced either on the deviation of weights or predefined time frame. Do not shortlist any scheme because it is star-rated or appearing in the list of 5 best mutual funds to buy for Diwali/Dhanteras.

Cost Matters

In the environment of falling yields, its very important to control costs in the form of fund management expenses and taxation. Investors should use products like PPF, EPF and Sukanya Samridhi in their long-term fixed income allocation. In fixed income mutual funds, TER/YIELD is a good measure to see how many portions of yield is being charged by AMC as management fees. Mutual Funds can tap the tax arbitrage between interest income and long-term capital gains (t>3 years).

 

There are many other things which all these four pillars can do to build a stronger and more transparent ecosystem but the writer has restricted the article till changes required for Fixed Income only.

Nishant is passionate about mutual funds and personal finance and can be reached at twitter handle @stepbystep888

Opinions expressed are the authors and should not be construed as investment advice from Kuvera.

 

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