Sebi’s overhaul of debt funds: Smooth for the most part, rough at the edges

Market regulator SEBI (Securities and Exchange Board of India) has been overhauling mutual fund norms across all dimensions over the past couple of years. When new measures came, they did in droves, as opposed to piecemeal steps we’ve been accustomed to seeing in earlier years. Thursday’s measures taken by Sebi after the board meeting was an account-taking exercise of the entire turmoil in debt funds that started in August 2018 when Infrastructure & Leasing Finance(IL&FS) debt securities were downgraded.

Increasing liquid funds’ portfolio transparency For starters, liquid funds will now have to mark-to-market their entire portfolio, as opposed to only those securities that matured beyond 30 days. The latter limit of 30 days was actually brought down from 60 days in March 2019. Why Sebi didn’t allow the entire portfolio to be marked to market at that time itself remains a mystery. Many debt market experts such as Arvind Chari, Head of Fixed Income and Alternatives at Quantum Advisors have for long been advocating that liquid funds should be asked to mark-to-market their entire portfolios. But by allowing a part of their portfolios to be amortised, the performance of liquid funds used to go up in an almost straight line. This gave a sense that they are less or not volatile. Expect your liquid funds to be bit more volatile than in the past. This is fine, as funds get more true to label. A liquid fund with its net asset value displaying its true underlying value looks and feels more realistic and is not a mirage. If you don’t like it, then stick to money-market or overnight funds.

Sebi has also attempted to clean mutual funds’ portfolios without really telling them which securities to buy and which to sell.

Tightening norms for lending against shares First, it said that mutual fund schemes shall not invest more than 10 per cent of their corpus in instruments having credit enhancements. A credit enhancement instrument is one that is backed by equity shares (as collateral) that belong to the promoter. These are also more popularly referred to as loans against shares (LAS).

Second, it has widened the scope of the term ‘encumbrances’ by including words such as pledge, lien, negative lien and non-disposal undertaking. Earlier, many such LAS instruments, though a pledge of promoter’s shares, used to escape scrutiny by hiding behind vague definitions. Now, promoters will have to club all of these pledged shares into one basket and explain if all these shares exceed 20 per cent of the total share capital in the company or 50 per cent of their (promoters’) shareholding in the company.

And third, it has asked funds to mandatorily have a security cover of at least four times. This norm is for investment by MF schemes in debt securities that are backed by promoter shares. In January this year, many debt funds were in a soup when the share prices of some Essel group companies fell. Many mutual funds had lent to the Essel Group against shares pledged by these companies. The security cover for all lending by mutual funds in this arrangement was around 1.5 to 1.75 times. In simple terms, if a mutual fund lends Rs 100 to the Essel group, the group would pledge shares worth Rs 150-175 with the mutual fund. If the share prices were to fall below this limit, then the borrower (Essel Group in this case) would make good the loss by paying cash to the fund. Or the fund house starts selling shares and recover cash to protect itself from any further slide in share prices.

However, the cover fell fast and furious when the share prices of the company corrected steeply. Instead of selling the group companies’ shares or demanding additional cover, fund houses gave a reprieve to the Essel group by asking it to repay its debt by September 2019.

Kaustubh Belapurkar, director, fund research, Morningstar India, a US-headquartered MF tracking and research firm, is quick to point out that a four times cover, when just 20 per cent of a company’s total share capital can be leveraged, means that the company can borrow only five per cent of the overall equity capital. And what’s more, by specifying the cover threshold (four times for all debt schemes that take promoter shares a collateral) it has implicitly told fund houses that under no circumstances the cover should fall. That is what had happened in the case of Essel Group. And then fund houses had entered into a stand-still agreement with the Essel group promoters giving them respite till September 2019. Sebi stopped short of imposing an outright ban on such stand-still agreements. But the above measures are good enough to ensure that no fund house walks down that path again.

The missed opportunity

What Sebi missed out was on what happens when an asset management company buys bad papers from its own debt schemes and takes the losses on its books. It’s a mystery as to why Sebi was quiet on this matter. Fund houses had done it in 2008 and they did it again in 2019—a large fund house bought some bad debt securities from its mutual fund schemes, paid off the money to the scheme and, in turn, the latter’s investors. Investors are happy that they get their money back when things go bad. On the flip side, they will never learn the true risk in a mutual fund scheme and therefore the need to buy a scheme that truly fits their needs. Taking bad securities on its books helps nurture the myth that, come what may, investors will never lose their money.