Downside of debt fund

New Delhi: Sebi recently modified rules specifying when a debt fund can restrict redemptions by inves tors. The circular essentially forbids a fund from closing its windows to investors who want out, just because it is unable to sell some securities. Unless there is a system-level crisis that impacts overall liquidity , a debt fund should not restrict redemptions.This is in line with the role and position of debt funds in the money and credit market.The practical difficulties in the area debt funds tread are quite challenging. Let us consider the context and its contours.
A market for credit is made up of lenders and borrowers. Intermediaries come in because lenders are unwilling to give money to unknown borrowers.Banks play the role of primary intermediary, raising money from lenders (depositors) and making it available to borrowers. While performing this function, banks engage in three levels of transformation: credit, maturity and liquidity . Depositors lend money to the bank.The credit risk they take is on the bank and its balance sheet. They don't bother about whom the bank is lending to. By standing in between, the bank transforms the credit risk of the borrowers to a much lower risk for depositors. This is why depositors accept a low interest rate compared to the bank's own lending rate.
Banks issue loans for varying periods of time. However, they accept deposits only for short periods. A bank that raises a three-year deposit and makes a 15year home loan, is carrying out a maturity transformation for depositors and borrowers. It manages this asset-liability mismatch on its balance sheet.
Banks allow depositors to access deposits at any time. A bank can't call back loans issued, but it does keep its promise of liquidity to depositors. This liquidity transformation function puts banks at the centre of the financial system.
For a bank to carry out all three levels of transformation, it has to be capitalised well, supported by the central bank for liquidity requirements and last resort funds, regulated to maintain reserves, and covered by deposit insurance.
When a debt mutual fund enters this space and offers credit, it has to perform the three transformative functions anyway . But it has to find private sources of support to pull it off. If these functions were to be conducted in a less developed market for credit, a debt fund would face challenges.
Debt funds perform credit transformation through portfolio construction and diversification. The credit risk of the investor is mitigated by the presence of multiple borrowers in a diversified portfolio of bonds. It is subject to regulatory limits on how much exposure it can have to a borrower, and to sectors.
However, this transformation is not as dramatic as what a bank can deliver.The depositor is a lender to the bank, while the investor in a mutual fund is a unit holder. Therefore, to further mitigate the credit risk to the investor, a debt fund's product features a daily NAV , that is marked to the current market value of the investments. Without a liquid market in which bonds are actively traded, this function is compromised.
The maturity and liquidity transformation function in a fund rely heavily on a liquid market for the bonds the fund invests in. A fund has to offer redemption and instant liquidity to its investors, and any sell-off at prices other than the valued NAV exposes other investors to risks.
Since debt funds are mostly open ended, they also have to manage inflows and outflows, which, in turn, can depend on the fluctuating NAV and the performance of the fund itself. Therefore, the transformational functions performed by debt funds are mutually dependent, and liquidity in the markets in which they operate determines how well they can perform these functions.
Consider the market realities. Banks, PFs, NBFCs and insurance firms are the dominant players in the debt market. But they are not required to mark their portfolios to the market or value assets as per current prices. Liquidity in government securities markets is limited. The secondary market for corporate bonds is quite illiquid, given that that there are no players who have to implement their views routinely , and care about the market value of their holdings.
In India, private back-up facilities for debt funds, such as credit guarantees, swaps, bridge facilities and liquidity adjustments, are not available. Debt funds construct a diversified portfolio and deliver market returns to investors, but have no fall-back for lack of liquid markets for bonds they hold.
The quality of credit portfolios of debt funds reflect both micro-level selection and macro-level credit cycles, as eager asset gatherers stretch their risk profiles trying to capture credit opportunities. Then market events kick in, calling for corrections and realignment. The NAV that dips with rating downgrades in bonds and collateralised debt, or an unexpected depreciation in currency , get corrected as funds make adjustments.Opportunistic products and providers die in the process. This spooks retail investors, who perceive debt funds as risky .
Debt funds perform an important intermediation function under severe constraints. We can regulate how debt funds will construct, value, disclose their portfolios, and how they will issue, charge and redeem investor funds. However, with adequate backstops and fall-backs for efficient intermediation in an illiquid market, debt funds will thrive, and that should be the focus of regulation.
Uma Shashikant is Chairperson, Centre for Investment Education and Learning