2008 was a nightmare for investors but lessons from that episode also led to an important regulatory change for a category of debt funds called fixed maturity plans (FMPs). This innovative, hot-selling mutual fund category conceived to save taxes, till then was structured as closed-end funds with early redemption options. During the crisis, as investors pressed the exit button due to fear of a default by real estate companies, funds had to liquidate their holdings at lower prices rather than hold their bonds to maturity and realise the full value. Ultimately, investors who held on till maturity also ended up losing because the holdings were sold off prematurely. Sebi thereafter made it mandatory for these funds to list in the stock market to provide liquidity to investors rather than the early redemption option that would unnecessarily punish investors who are willing to stay the course.
Fast forward to 2015. There is a sense of déjà vu. This time the villain is different, but the script is similar. A few days ago, JP Morgan AMC imposed a 1% cap on redemptions on its two debt schemes to limit exits by investors worried over the schemes’ exposure to Amtek Auto. JP Morgan India Treasury Fund, an ultra short-term fund had an exposure of more than 5% to AA rated Amtek Auto’s debt papers, while JP Morgan India Short-Term Income Fund had more than 15% exposure to the bonds. There has been speculation for a while over this auto ancillary company defaulting on its obligations as it reels under a mountain of debt while its cash flows have been grossly inadequate. According to a fund manager who did not wish to be identified, Sebi is closely looking into the issue of dealing with default risks and the associated panic redemption. This lingering problem stems from the illiquid nature of corporate bond holdings and the asset-liability mismatch in these schemes. The latter is a common problem with all open-end funds which hold illiquid securities.
The first problem regarding the valuation of corporate bonds has always been a touchy issue, but the current economic environment where credit risk looms large, has only turned the spotlight back on this issue. Since corporate bonds are not often traded, their value is usually not captured in the net asset value (NAV) of the funds or the price at which unit holders buy and sell. When credit quality deteriorates, it is quite possible that exiting investors may be redeeming at a price that does not capture the lower value of the security even though the bad credit sits on the fund’s book like a time bomb. When the credit explodes, the fund's NAV will fall suddenly inflicting a disproportionate loss on the remaining investors. Last week, JP Morgan AMC was in the news for not just capping redemptions, but also for allowing certain corporate investors a preferential exit. For JP Morgan’s India Treasury Fund, the concentration risk was not only in terms of exposure, it was also on the liability side. As on March 31, 2015, among BSE-100 companies, Cairn India (₹250 crore), Hindustan Zinc (₹398 crore) and ITC (₹102.28 crore) together had investments of about ₹750 crore in the India Treasury Fund and accounted for 48% of the total assets under management of ₹1,546 crore. Its Short-Term Income Fund, however, did not have any investments from BSE-100 companies during the same period.
Vidya Bala, head, mutual fund research, FundsIndia says that the purpose of an ultra short-term fund is to park money temporarily and earn a slightly better return than a savings bank rate. In theory then, no element of credit risk should creep into such funds by way of risky/illiquid debt instruments but the reality is quite different. An analyst who requested anonymity says that institutional investors’ clamour for better yields often compels fund managers to take undue risks. Institutional money is largely held in liquid or money market schemes or other short-term debt funds for better returns than bank rates and easy liquidity. As per available data, institutional investors’ mutual fund asset base stood at ₹600,000 crore as on December 31, 2014, while individual investors’ asset base stood at ₹525,000 crore. For perspective, institutional investors accounted for 54% of mutual fund assets and of this corporates had the largest chunk at 47%.
Need for quick fix
Experts add that the Amtek Auto case also raises questions on credit rating agencies’ ability to sniff problems before they become a raging issue. In the case of Amtek Auto, it was after the company said that there was a temporary mismatch in its cash flow in response to BSE in a news report that Brickwork Ratings downgraded the Amtek Auto bond from A+ to C. Following this, Crisil and Icra reduced the valuation of the bond by about 25%. This resulted in a sharp fall in the NAVs of JP Morgan funds as Sebi rules require fund houses to value bonds based on the valuations of debt papers by the two credit rating agencies.
The problem is that the shallow nature of the corporate debt market and illiquidity of the underlying assets makes both efficient price discovery and offering a continuous redemption window a difficult proposition for mutual funds. How should then mutual funds manage their exposure in a way that the NAV does not explode one fine day? The earlier unnamed fund manager says that when a fund house senses problems in a particular company, it should proactively mark down that paper and provision for it. While that suggestion is sensible, it seems easier said than done.
Some industry insiders feel that mutual funds should adopt risk-management practices similar to those followed by banks. Maneesh Dangi of Birla Sun Life AMC, says, “We have recommended to Sebi that mutual funds also should maintain something on the lines of statutory liquidity ratio for banks. Under this framework, every AMC would be required to maintain at least 25-30% of their debt portfolio in either government securities or commercial paper and corporate debentures with three-six months maturity.” The question is whether that will take the investor away from debt funds because the reserve requirement will be a drag on funds. But Dangi feels “while such an arrangement would hurt the return profile of the funds, it will be a prudent step.”
Industry observers also feel that the structure of an open-end debt scheme itself may need some tinkering with. “Any fund with exposure to illiquid assets should not be an open-end fund. They can be interval funds with restricted liquidity or closed-end funds like FMPs because creating a fund that causes panic or cannot deal with panic or a massive exodus is a problem,” says Dhirendra Kumar of Value Research.
Bala feels that fund houses should have an internal segregation of liquid and illiquid assets in a scheme based on the fund duration. If a crisis emerges in an illiquid instrument and investors panic, fund houses can then allow redemptions from the liquid part of the portfolio. Not only will this ensure that there is liquidity, it will also make it easy for the investors to assess the liquidity risks in such schemes. This is precisely what JP Morgan AMC plans to do with the afflicted schemes. It has now proposed to split each of the India Treasury and Short-Term Income schemes into two separate units – one with exposure to Amtek Auto and the other with cash holdings and other investments.