Mutual Fund investments are subject to market risk, read the offer document before investing.
A very familiar disclaimer, it appears at the end of every advertisement of mutual funds (MF) that we come across on a daily basis. This statement was apt for investors who always chose to invest in equity MFs. However, now looking at the events that unfolded during April 2019, this disclaimer seems to be befitting Debt MFs too.
Trouble started brewing in the MF sector since April with six fund houses having exposure to the troubled debt papers issued by the Essel Group and IL&FS companies, waiting to take a call on how to handle the redemption of fixed maturity plans (FMP) in the next three months.
These fund houses may either withhold returns or offer investors an option to roll over their investments.
Unlike Kotak Mutual Fund, which withheld the returns of its close-ended FMP that matured on April 10, HDFC MF offered an option to the investors of its FMP maturing in April to roll over their investment for 380 days.
FMPs of five mutual funds — Reliance, Aditya Birla Sun Life, DSP MF, UTI MF and DHFL Pramerica — with exposure to distressed Essel and IL&FS group companies will mature in the next two months.
Of the FMPs with exposure to the two distressed companies, 56 schemes are maturing this year. Among them, 45 have exposure to the Essel Group and 11 schemes have invested in IL&FS. Similarly, two schemes, each of Kotak and HDFC MF and six schemes of Reliance MF are maturing in May, while one scheme of UTI MF is maturing in June.
What are FMPs? FMPs are fixed tenure mutual fund schemes that invest in debt instruments including government securities (G-Secs), commercial papers (CPs), non-convertible debentures (NCDs) and certificate of deposits (CDs) among others and thus generate interest income for investors. They are close-ended funds that mature after completion of a pre-determined time period.
The case in question is, investors who had capitalised their money in Kotak MF’s FMP on November-December 2015, were ideally supposed to get their capital along with interest income on the date of maturity, April 10, 2019. However, since the fund house had high exposure (almost 27per cent of initial corpus) to IL&FS Transportation Networks Limited and two Essel Group companies that are facing liquidity crisis, the fund house was not in a position to fully honour its commitment. It said that it had repaid 99.25 per cent of the investors’ initial investment, and that it was working towards optimal recovery from two Essel Group companies by September 30, 2019.
How severe is the issue? On the face it might not be possible to understand the severity, but the problem is much bigger and runs deeper than what the news has been. This is precisely the reason why everyone is requesting for anonymity.
According to market observers, the companies that have defaulted on interest payment and are involved in other breaches, all had high rating before default. Others that have not yet defaulted should not be construed sound and safe.
Some of the more informed ones claimed that besides MFs, even insurance companies too have significant exposure in structured debt or collateralised loan obligations (CLOs). Together, both categories of institutional investors—MFs and insurance companies have put together sizeable chunk of funds in such products. It is just a matter of time that this will be revealed as we are currently passing through seven phased general elections.
Have MFs gone beyond their mandate? Analysing this, it can be said that MFs have invested in risky instruments like structured debt, CLOs and loan against shares (LAS), which are not commensurate with risk profile of FMP investors, who are typically ultra conservative.
Just because there is no explicit prohibition on CLOs, that does not mean such investors should venture in those that are non-commensurate with philosophy, scheme mandate and risk profile of investors. Had they disclosed in offer document that they would make such adventurous investments because the capital market regulator Sebi does not prohibit them to do so, asked one market observer.
So how is Sebi dealing with this issue? It is examining the legal tenability of the approach taken by fund houses. “The regulator wants to know if fund houses can do more to safeguard investors,” said a source privy to the development. According to him, asset management companies (AMCs) have cited Sebi’s 2012 circular on handling toxic assets and recent side-pocketing norms behind their move. Under side-pocketing, a fund house can segregate a bad asset from a good one. By doing so, there is a hope of recovery. The market regulator, however, is probing whether the provisions have been followed.
Sebi is concerned that MFs may have gone overboard in lending promoter group firms and that the structures through which the loans have been given are opaque. MFs’ total exposure to debt securities of promoter-owned entities is not known. This is the first time Sebi is formally assessing the industry’s risks involving such structures.
However, this is not the first time. FMPs have been in trouble in the past too. In 2010, closed debt schemes faced repayment crisis, when BNP Paribas and Deutsche MF had exposure to Vishal Retail, which had defaulted on interest payment. As a result, Sebi found two AMCs defaulting on debt repayment. Regulator had then directed fund houses to revise the valuation of debt instruments and the troubled FMPs received fair NAV after the revision of the value.
What should be the way out? Can Sebi pull it off? If so, then how should it handle the situation this time? Should MFs be banned from offering structured debt products and equity based loan against shares (LAS) products? Or it should be banned completely for MFs?
Somsekhar Vemuri, Director, CRISIL Ratings disagrees. According to him, “It should be allowed at a very high level of cover for LAS. MFs should be asked to take cover of at least five to six times of the amount of the debt to be raised. Then the promoter will be in a position to roll over their debt exposure or refinance it, when maturity happens. Yes, there is still a risk which debt investors are taking, it is something which probably is more than compensated by the return, which is more than the interest rate and with the five to six time cover, safety is associated with the market crash of that order compared to the current situation where the cover given to MF lenders is fairly inadequate”, he added.
Commenting on the issue, Sandesh Kirkire, an expert on fixed income sector and professor at Jamnalal Bajaj Institute of Management Studies, said, “Of course, when one invests in debt, there is credit risk; so lower credit could find its way into a credit FMP”. He has suggested Sebi to tighten its regulatory controls over MFs and FMPs in particular.
According to Kirkire, Sebi cap the investment in equities at 10 per cent of the net asset of the fund, while it is 12 per cent for debt securities with a group investment capped at 20 per cent of the scheme assets. So, the tighter cap is not for an illiquid asset but for a liquid asset class. With a 20 per cent cap at the group level, many of these FMPs have less than 10 securities in the portfolio, again defying the basics of a mutual fund, which is diversification. There is a case to cap corporate credit at 5 per cent of net assets or lower; this would significantly reduce the risk and perhaps the timing is right, as the Reserve Bank of India (RBI) is now making it mandatory for corporates to access the bond markets as a proportion of their total bank borrowings. Of course, this will also reduce the spate of FMP launches due to the unavailability of sufficient credit assets in the near term.
Kirkire further stated that, more and more investors will start looking at fund portfolios. Sebi should make it mandatory for funds to indicate the names of the promoters of all investee companies in the disclosure document. Further, fund houses manage debt fund redemptions at the fund level instead of scheme level. Due to this, there are a lot of inter-scheme transactions to manage liquidity. So, an investor who does not like a particular instrument and invests in a fund after looking at its portfolio could see that instrument coming back into the scheme through an inter-scheme transaction that is undertaken at a later date. Therefore, there is a need to stop inter-scheme transactions or at best, restrict them to 30-day securities that are amortised to maturity and manage liquidity at the scheme level. This should be done for equity schemes as well, he said.
Having said that, recent developments in the MF space are increasingly making the investment process for retail investors more complicated, confusing and intriguing.
In such a scenario, can we say that mutual funds really make for a good investment? Well, that is the question we ask!
yagnesh@outlookindia.com