What makes managing debt funds a challenge for mutual funds industry

Illustration: Binay Sinha
The strongly worded statement of Securities and Exchange Board of India (Sebi) Chairman Ajay Tyagi asking the mutual fund industry to behave like “investors” and not “bankers” comes at a time when Franklin Templeton Mutual Fund has shut down six of its debt fund schemes, with assets under management of Rs 30,000 crore. More importantly, 300,000 investors have been adversely impacted due to this decision. Last week, Sebi itself was criticised by the Karnataka High Court for the handling of the closure of Franklin’s schemes.

But Tyagi is not the first one to propose new guidelines for debt funds; other Sebi chiefs have had to do the same in the past two decades — U K Sinha brought in strict guidelines during the Amtek Auto rating problems in 2015 and so did C B Bhave in 2008 after the fixed maturity plan fiasco.

Managing debt funds has been a challenge for the mutual fund industry since its inception. Given that debt funds, at Rs 12.61 trillion in August, have a large share of the total assets under management (AUM) of the mutual fund industry (total AUM at Rs 27.49 trillion) — in fact more than equity schemes — this is worrying.

Says A Balasubramanian, CEO, Birla Sun Life Mutual Fund: “Given the bond market is impacted by a lot of things — the economy, the Reserve Bank of India’s outlook and so on — the debt market gets constantly affected by these moves. So, Sebi’s intervention or changes in guidelines are required to reflect the change in the market realities.” And he should know. He has spent over 25 years in the debt market.

Says Dhirendra Kumar, CEO, Value Research, a Delhi-based mutual fund research firm: “It is a complicated issue. It’s not that debt funds earn too much money for the asset management companies. But it gives them size. And size gives fund houses leverage.”

Kumar makes an interesting argument: An equity investor can replicate 95 per cent of an equity fund manager’s portfolio. The remaining 5 per cent cannot be replicated because of inflows/outflows that a scheme can face, unlike an individual. Therefore, it is more or less a liquid portfolio.

However, it is difficult to do the same for debt funds. This is because retail investors will not have access to money market instruments or deal with companies directly. “So, debt funds provide liquidity to a portfolio, which may not be liquid in the true sense,” he adds. And there will always be trouble when investors rush to liquidate.

So, even Sebi’s latest set of proposals, which Tyagi articulated in the event, may have limited impact. The four options — extension of repo (lending) operations, creation of a backstop mechanism, minimum cash holding of 10-20 per cent and swing pricing that will impose a cost on investors making large withdrawals — are all good steps. According to Balasubramanian, the backstop mechanism is a good option because it will bring in a system where even illiquid papers will be bought by an entity in times of crisis. While the Sebi chairman did not elucidate how this entity will be funded or formed, fund managers are happy that such a mechanism is being proposed. “This will deepen the corporate bond market significantly,” says Balasubramanian.

But all guidelines face two key challenges — herd mentality among investors and absence of a deep corporate debt market.

Debt fund managers have faced these challenges all these years. Even if a scheme has 20 per cent in cash, if 50 per cent of investors (sometimes encouraged by distributors as well) decide to redeem at the same time, this reserve will never be enough — something that the Franklin Templeton schemes witnessed in March. And no amount of exit load, as a deterrent, can stop them. In 2008, fund houses faced redemptions on their fixed maturity plans despite exit loads of 5 per cent and more.

Hemant Rustagi, CEO, WiseInvest Advisors, points to several other problems that debt fund managers face — pressure of keeping up with the mandate, pressure of higher returns and timing of inflows. “I have stopped recommending debt funds for many years since there has been an erratic change in the interest rate cycle. And the money generally flows into these schemes when the interest rate cycle is bottoming out,” he says. For example, a lot of money was coming into debt funds when interest rates were falling in recent times as it translated into higher bond prices, improving returns significantly — quite similar to money coming into equity funds when stock markets are nearing all-time highs.

However, when the cycle turns quickly, both fund managers and investors are left in the lurch. “There is no concept of cost averaging in case of debt unlike in equities, so the fund manager has no option,” adds Rustagi.

Then there are mandates, that is, credit-risk funds need to keep at least 65 per cent of their money in AA- or lower-graded papers. So, the fund manager has to take this risk. And such companies suffer the most when the economy is on a downward spiral, leading to delay/default in payments.

Most experts believe that till there is a good secondary market in corporate bonds, debt funds will continue to go through these ups and downs. Solutions? Balasubramanian believes that Sebi will have to, from time to time, bring in certain guidelines and smoothen the process in line with the new challenges that debt fund managers are likely to face. Rustagi, on his part, believes that the market regulator should increase the investment limit for retail investors for some of the risky categories like duration and credit risk funds. “That will limit headaches and inflows,” he adds.

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