In the wake of the recent liquidity crisis, the Securities and Exchange Board of India (Sebi) in its board meeting last week tightened certain investment and valuation norms for debt funds including liquid funds to protect investors from credit as well as liquid risk. These changes have come in the aftermath of the recent non-banking finance company (NBFC) crisis which started in September 2018 after IL&FS Group companies defaulted on payments. The default turned lenders cautious about lending to NBFCs resulting into a credit squeeze. Several other companies -- where mutual funds had invested -- also defaulted on payments, hitting investors hard.
Based on the recommendations of the Mutual Fund Advisory Committee (MFAC), Sebi has introduced following key changes governing debt funds and investments in debt and money market instruments.
1) Mandatory liquid assets: Liquid funds will have to hold at least 20 per cent assets in cash, government securities, T-bills and repo on government securities. "The regulator is looking to reduce liquidity risk in liquid funds by asking fund houses to invest at least 20 per cent of the portfolio in cash and equivalents," says Kaustubh Belapurkar, Director - Manager Research, Morningstar Investment Adviser India.
2) Sector exposure cap reduced: Now, the exposure to a single sector will not go beyond 20 per cent as against 25 per cent earlier. The additional exposure of 15 per cent to housing finance companies (HFCs) should be restructured to 10 per cent. With this, Sebi is trying to reduce the concentration risk, says Belapurkar.
3) Mark-to-market: All debt papers in debt funds will be valued at mark-to-market while valuation based on amortisation will not be used by mutual funds any more.
In April, Sebi revised valuation norms of debt funds, asking them to mark-to-market securities of maturity over 30 days. Earlier, securities with maturity of over 60 days were to be mark-to-market while those with lower tenure were to be valued on amortisation basis. After Mark-to-market, the growth in mutual fund's NAV will not be linear and NAVs will become more volatile but the valuation will be more realistic as against in the case of amortisation," says Arvind Chari, Head, Fixed Income, Quantum Mutual Fund.
4) No structured obligations: Liquid and overnight schemes will not be allowed to invest in short-term deposits, debt and money market instruments having structured obligations or credit enhancements. "Liquid funds are not supposed to be investing in structured obligations. Capping the limit in other funds is also a good move as structured obligations may not be that liquid," says Arvind Chari, Head, Fixed Income, Quantum Mutual Fund.
5) Exit load on liquid fund: A graded exit load should be levied on investors who exit liquid fund in seven days of investing. Mark-to-market valuations along with exit load may move investors from liquid funds to overnight papers, believes Chari.
6) Invest only in listed NCDs and CPs: Mutual funds will be allowed to invest only in listed non convertible debentures (NCDs) and commercial papers (CPs). They will be given enough time to comply with these regulations as currently there are no listed CPs. "Listed securities have to comply with certain disclosure norms of the exchanges as compared to privately placed papers or unlisted papers. This move will bring in more transparency and improve quality," believes Chari.
7) Security cover of four times: For investment by mutual fund schemes in debt securities having credit enhancements backed by equities directly or indirectly will have to have a cover of at least four times. This has come in the wake of the loans to Zee against shares where the share collateral proved inadequate. A higher cover will ensure adequate collateral.
8) Cap on debt papers with credit enhancements: Mutual funds have invested in debt instruments with promoter guarantee or shares as collateral. Such instruments generally offer higher yield. Sebi has capped the exposure to such instruments to 10 per cent of portfolio and five per cent to a group. This will help reduce the credit risk across funds.
The investment fraternity lauded these regulations, saying the new rules will bring in more transparency and liquidity in debt funds.
"I strongly feel Sebi measures are in right direction to protect investor interest and get confidence back in liquid category of debt mutual funds. I feel current NBFC crisis is making investor nervous about debt mutual funds. Overall, it is important to take some hard decisions to win back investor confidence and make this industry more investor friendly," says Tarun Birani, Founder and CEO of TBNG Capital Advisors.