Why SEBI needs to strengthen rules to protect investors in debt mutual funds

Recently, a journalist asked me whether retail investors need to be more careful with their debt mutual funds, in the context of the recent credit risk issues. My reply was, ‘Can they, really?’ When the Essel group issue came to light, it took our entire research team several days of analysis and follow-ups with fund houses before we could wrap our heads around the problem. There were name changes, missing information, and several crossholdings to decipher. Can we even imagine the plight of a regular investor?

This question gains significance now as the proportion of individual investment—retail and high net worth individuals (HNI)—in debt and debt-oriented products is not small. It was 36% in March 2019. Even in an institutional category, such as liquid and money market, retail and HNI holdings are close to 20% of the assets. With increased awareness about asset allocation and tools like SWP (systematic withdrawal plan) for steady income, this percentage has only been going up.

Impact of redemptions
The funds that held bonds which were impacted or downgraded (IL&FS group, Essel, ADAG and DHFL) adhered to regulatory norms. However, for many schemes, the impact of write-offs from downgrades or defaults was harsh. Funds had to exit better-rated bonds to meet redemption requirements, which raised their concentration in riskier bonds. Such redemptions were typically done by corporate and large investors, who sensed trouble or were privy to select information. In the past eight months, funds’ exposure to several risky bonds has risen from 7-8% to 30-40% due to large redemptions. This was followed by a downgrade or default and a sudden markdown in funds’ NAV, leaving retail investors wondering whether to continue with the fund or exit after the hit.

Were we better off in the era of separate NAVs for retail and institutional investors? While there were some anomalous practices associated with two NAVs, the current system victimises the retail investor for being a tortoise and not a hare. Has the regulator thought about the impact of redemptions on retail investors where the portfolio is filled with risky or illiquid bonds?

Inter-scheme transfers

Concentration risk comes to light, even if it is late, but inter-scheme transfers seldom do. These are indeed a legitimate way to transfer assets from one scheme to another within the fund house. But the practice remains opaque, providing room to fund houses to ‘shift’ risks too. A few months ago, my team came across bonds shifted from a very shortterm debt scheme to a credit risk scheme. This was just months before the IL&FS crisis. There can be many reasons for this. However, the fact that risk was shuffled and shoved under ‘credit risk’ and removed from a pro-institutional product does shake one’s confidence. If a bond had been identified as seriously risky, it shouldn’t have found a place in any fund. While the regulator has always frowned upon inter-scheme transfers, the current norms only require that these be disclosed, and no justification is needed. How will a retail investor learn of such transfers and understand the reasoning behind them? How can they evaluate this risk?

Does categorisation help?

Sebi’s efforts to get fund houses to invest the way they classify their schemes are appreciable. However, one wonders if the classification was done considering the ‘real problems’ faced by investors. While it will need a separate essay to talk about equity, in debt, it is about the credit risk.

While Sebi chose to classify most debt fund categories according to duration, there has been no mention of the level of credit risk they can carry. Credit risk funds and corporate bond funds are the only categories where rating criteria is used. This essentially means that ultra short-term or short-term funds are free to take risks. However, the fundamental questions of whether risks should be allowed in short-term funds and what is the fallout of such risks (considering credit risk is almost always compounded by lack of liquidity) have not been considered in any categorisation. Therefore, we have seen many ultra short or short-term funds coming under stress in the recent spate of downgrades/defaults. Many retirees or income-seeking investors are advised to invest in short-term accrual funds and opt for SWPs. Even an earnest adviser, who seeks to protect his clients, may be in for a rude shock when there is a spate of downgrades or a sudden concentration risk that impacts such seemingly low-risk funds.

These are but three issues that have come to light. One can’t help but wonder what other problems are lurking in the shadows. Fund houses are aggressively marketing debt funds to retail investors. These are positioned as having ‘lower risk’ and for ‘regular income’. But recent events have shown that debt funds are far from being retail-friendly products. However, every crisis is an opportunity to improve.

It is imperative that the regulator understand the pain points of retail investors. Fund houses and their bodies cannot be expected to provide the needed inputs. Finding solutions by working with fund houses and rating agencies, along with inputs from the advisory community, is the need of the hour.

This article was first published on Economic Times.