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After Franklin earthquake, inside the race to fix debt funds

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The biggest jolt – now a topic of angst for 300,000 investors – came on 23 April when the eighth largest Asset Management Company (AMC) shuttered six of its debt schemes. Franklin Templeton India’s decision was shocking and raised concerns that perhaps debt mutual funds were not immune to the economic slowdown that has followed in the wake of the pandemic.

The pain of Franklin’s investors is set to prolong as the process of refunding is now mired in court battles. Last week, Gujarat High Court in a ruling stayed the crucial e-voting process required under Securities Exchange Board of India (sebi) regulations at least until 12 June. The Gujarat court is debating whether the manner in which the funds were wound up is itself illegal.

A second case is before the Madras High Court, which has issued notices to the AMC and the market regulator seeking a report on the refund exercise. n the coming days, the matter is likely to escalate as a clutch of high net-worth individuals (HNIs) have filed another case in the Supreme Court alleging malpractice. Another case has been filed in Delhi High Court too.

Over the past month, an initial round of frustration was directed toward Franklin Templeton, after which, investors turned their ire against the entire industry on social media. Soon enough, a corrupted form of the mutual fund industry’s tagline began trending on social media platforms: #MutualFundsSahiNahiHai (mutual funds are not good for investors).

Repeated crises within India’s debt space (a supposed safe-haven), and the unfolding Franklin fiasco, is now starting to change the landscape of debt mutual funds in profound ways. The once blooming credit risk funds have been reduced to less than half their size in just one year. Credit risk funds are those which invest at least 65% of the money in lower-rated bonds and they may not find many investors for the foreseeable future.

There are also more regulatory checks and heightened disclosures in the offing. These would focus not just on where the money is being invested, but also on who the large investors are and their redemption patterns. This is to ensure that retail investors are not left holding the bag after savvy investors have withdrawn their money.

The archaic and thoroughly ambiguous Sebi rules which govern the winding up of mutual fund schemes would also need ample tweaks.

Meanwhile, fund managers have already done a swift U-turn. They had just started testing the waters with attempts to innovate in debt, but have now reverted back to taking safer bets.

Apart from investors, what these shifts could mean for the overall economy is another puzzle altogether. Business funding in India is heavily reliant on bank credit (almost 60%). Private debt instruments and corporate bonds were beginning to get a fresh lease of life only in the early part of this decade. Now, bank lending has frozen, debt funds are suddenly not kosher, and business is at a standstill.

“Fund managers were just beginning to bet on the debt of less-tapped companies which in turn would have led to increased tradability,” said Sivakumar, CIO, Fixed Income, Axis Mutual Fund. “The fallout of this crisis is the industry is now reverting back to taking safer bets such as super-rated paper or government securities. This is unlikely to change anytime soon, which is definitely unfortunate as it will set back the development of the debt fund industry by a couple of years at least.”

Credit appraisals

For years, debt funds have been relegated to being the poorer cousin of equity funds. The equity market is where the glamour is and the debt market, despite numerous white papers, is still discreetly called the “dead market” in industry conferences.

So, it should not come as a surprise that research on the credit risk of debt funds took a back seat. While equity teams with full-fledged research teams were set up at the onset of India’s mutual fund boom, the earliest credit assessment on debt started only after the 2008 Global Financial Crisis. But the number of AMCs who woke up to the need for adequate credit assessment was not even 10.

Incidentally, it was around that time that Franklin Templeton decided to get creative with debt, with some credit research to back it.

“Franklin’s strategy toward debt was clear. It was taking credit risk. It will take unique calls for the sake of higher return to investors. But out of ten bets, two could go wrong,” said a sales head executive at a leading fund house.

Risk on credit is when an issuer can default, which leads to a loss of principal as well as interest. But the reward on taking the right call could mean higher interest returns on riskier bonds.

Other fund houses which were initially jittery about such a strategy lost a lot of business to Franklin Templeton’s debt schemes. They had to change gears due to pressure from their internal sales team.

As a result, post-2010, many AMCs rushed to include credit risk in their fund portfolios. For more than a decade until then, debt fund managers were exposed only to interest rate risks that come from investing in government securities (g-secs).

But as the shift toward lower-rated bonds began, additional pressure points were building up: the market for the lower-rated paper was nascent, too shallow, and hardly found any buyers in the open market. So, even a few defaults (a reasonable expectation in a credit risk pool) could potentially set off a liquidity trap.

“The underlying corporate debt market has been under development for the past 25 years, but it continues to suffer from a lack of liquidity,” said A Prasanna, Chief Economist at ICICI Securities PD. “The hope is that as recovery and resolution mechanisms mature in India, the market will also become deep,” he added.

Inevitable faultlines began to appear as early as August 2015, when JP Morgan stopped redemptions in two of its schemes due to a rating withdrawal of the underlying paper of Amtek Auto.

But the real rude awakening was the sudden downgrade and default at Infrastructure Leasing and Financial Services (IL&FS), which up until September 2018 was a high-rated paper, said Sujoy Das, head (fixed income) at Invesco Mutual Fund. After IL&FS, it was a pack of cards – mutual fund investments in the papers of Dewan Housing Finance Ltd, Yes Bank Ltd, Essel group companies went bad in succession.

“Equity is decently understood by most stakeholders due to its long history. But on the credit (risk) side, there is lack of understanding. Fund managers were typically experts on interest rate risk and not credit risk,” said a risk manager at a leading fund house.

This lack of expertise in evaluating the underlying risk resulted in almost all AMCs outsourcing key functions. Judgement to invest in papers was left almost entirely to rating agencies and not based on internal due-diligence.

Until the faulty mechanisms inherent in the ratings game blew up along with the collapse of IL&FS, risk assessment in many AMCs was just a one-man department. At times, equity research was asked to assess credit risk of debt paper as well. This was a fundamentally flawed strategy. While equity is about future retained profits, debt is about continuing cash flows sufficient enough to repay regularly. “Credit decision ideally cannot be left to one person (fund manager) as the cost of going wrong is too high. Rating is just one input,” said a credit appraisal officer at mid-sized AMC.

In end-2018, Sebi advised firms to not rely solely on credit rating agencies, but instead, attempt their own credit assessment.

“After IL&FS, we added parameters such as a borrower’s ability to raise new money continuously; whether investors are increasing overtime; the secondary market liquidity (tradability) of the underlying paper,” said Das of Invesco.

But what the Franklin saga has revealed is that these preliminary steps toward informed risk-taking have come a little too late. While funnelling investor money into high risk-high reward debt was essential to widen the base of India’s corporate debt market, it should have ideally been accompanied with better systems to evaluate the underlying risk. But, for the last 10 years, investors largely walked in blind. Will that change?

Regulatory gap

While Sebi has directed AMCs to consider their own research to evaluate credit risk, it is not yet mandatory. Sebi regulations still mandate that fund houses use the ratings of rating agencies while making investment decisions.

Sebi rules decree that liquid funds should keep aside at least 25% of their assets in cash and cash equivalents in order to meet redemption pressures. But this is not required of other funds.

“Sebi has allowed credit risk funds, corporate bond funds, and PSU and banking funds to hold an additional 15 percent in g-secs. We are mulling whether during credit events, this can be made mandatory,” said a regulatory official who did not wish to be named.

Another big gap is Sebi’s categorisation of funds. In October 2017, the agency had decided to re-categorise funds to reduce the clutter of ‘me too’ funds. The initial intent was to reduce the 2000-odd funds by exactly half. But the final shape created too many categories. In debt funds, the issue is pronounced as one category is defined on the basis of when the bond will return the investment and another set is defined by rating or credit profile of the paper.

In the case of Franklin, it took credit bets in the income funds and even had bonds maturing in 2029 in its ultra-short-term fund, which needs to have an average duration of 3-6 months (the time it will take for a bond to repay its value).

“Mutual funds need to invest in specific average maturity instruments to be called short term or ultra-short-term, etc. They instead repackage a long-term bond as a short-term one using a floating rate bond which resets interest rate payable, say, every six months, and that will meet the regulatory norms,” said Deepak Shenoy, CEO at Capitalmind Wealth.

Sebi also provided funds with an escape clause by using average duration to categorise, which allowed funds to average long and very short term paper and yet meet the fund investment criteria.

Going forward, both the credit profile and duration of the paper should be used to categorise funds to avoid fund managers taking credit risks in funds where they are not supposed to, said Pankaj Pathak, Fund Manager – Fixed Income at Quantum Mutual Fund.

The way ahead

Using the current atmosphere to overregulate would also be a mistake, said Nilesh Shah, CEO, Kotak Mutual Fund.

“Beyond a point too much prescriptions will lead to moribund capital markets , inefficient capital allocation and lack of innovation on products to cater different risk return appetite. Let there be a blend of risk and return to meet investor appetite,” said Shah

One thing which Sebi could immediately do is mandate fund houses to have internal credit assessment systems and remove the obligation to purely go by the ratings of rating agencies.

Sebi could also use this opportunity to dust and update the provisions on the winding up of schemes. While Sebi has allowed the units of schemes being wound up to be listed, the lack of liquidity in the underlying papers will render this exit unviable for majority of investors.

The 1996 provision used by Franklin to wind up its schemes is vague and unclear. What if Franklin does not get the required 50% share of the vote from its unitholders to start the winding-up process? Will Franklin have to go to the unit holders with a fresh proposal? Will Sebi intervene? Should Sebi not ensure a time-bound refund process?

When the investment of 300,000 investors amounting to 25,658 crore is at stake, such ambiguity in law and regulations is concerning. Since the mid-1990s, a lot has changed with India’s mutual funds industry. Perhaps, it is time for the regulator and regulations to wake up to these changed realities.

(Neil Borate contributed to the story.)

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