Debt Funds - SEBI Regulation and Impacts

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Introduction

Indian Mutual Fund industry currently manages around Rupees 26+ lakh crores worth of investor’s money. Is this managed in a transparent and in the interest of investor’s? It is highly doubted and debatable because of the recent events that have happened in the last one year in Debt Mutual Funds. The debt mutual fund is in turmoil. This started when IL&FS defaulted last September. This trend is continuing with the recent default of DHFL. It seems like a never-ending issue for debt mutual funds. In this backdrop and circumstance, SEBI on June 23^rd introduced some new regulations which will improve the way debt mutual funds are run by the mutual fund industry. 

In this article let us understand what the regulations are and how they impact ordinary investors.

1. Cash and cash equivalent in liquid funds increased

In liquid funds cash or cash equivalent should be 20%. This should preferably be in government securities so that it can be easily converted to cash. In most of the funds the current cash holdings of liquid funds is less than 20%.

Impact: When liquid funds are struck with non-performing assets, it is usually very difficult for the fund house to pay redeeming investors. This change will help investors of the liquid fund to exit easily to certain extent. Increasing liquid mandatory assets will help the investors who wants to exit these funds.

2. Sector exposure is reduced from 25% to 20%

Earlier debt funds can invest 25% in a particular sector. For example, pharma, housing, etc. Because of repayment obligation troubles in housing finance companies and non-banking finance companies, to reduce the risk, sector cap is brought down to 20%.

Impact: This will help to diversify investments in the portfolio. This will help mitigate the risk and reduce the impact of concentration in a single sector.

3. NAV should be calculated based on market value

All debt Investments should be marked to the market and NAV should be arrived based on the market value only. Amortizing interest should be discontinued.

Impact: The NAV chart will not be in a straight line as it used to be in the past. We can expect some fluctuations in NAV because of the market price movements.

4. Liquid and overnight funds should not invest in structured obligations

When debt funds are investing in corporate bonds, the security/collateral is structured in different ways between the corporation and the fund house. These methods are debatable and sometimes not in the interest of the investor. In some cases, the fund house will not be able to get back their money upon maturity. A way out as in the old structure is not possible under the new circumstances. Going forward liquid and overnight funds should not be entered into a structural obligation.

Impact: The risk is reduced in liquid and overnight funds. True to their label, they will be less risky. Returns may be low.

5. Exit load for liquid funds

So far there is no exit load for liquid funds. Going forward if investors are redeeming within 7 days, then they will have to pay a marginal exit load.

Impact: Because of the exit load, it will not be a very attractive investment to invest in liquid funds for less than 7 days. Hence it is expected that an investor who wishes to invest within 7 days might move into overnight funds.

6. Invest only in listed NCDS

Mutual funds should invest only in NCDS which are listed in the market. Private placement by promoters with mutual fund industry is restricted.

Impact: Since investment is permitted only in the listed securities, it will be helpful for the fund house to exit their investment at any point of time by selling the bonds/NCD in the market. Indirectly this will help the investor to exit the funds easily. This makes these investments more transparent.

7. Security cover should be four times

When corporations get money from mutual funds, they usually provide shares as security. The value of the shares should be at least two times more than that of the loan. Now it is increased from two times to four times of the loan. For example, if mutual fund industry is giving hundred crores to a particular corporation, they usually should provide security for the value of 200 crores. Going forward they should provide security cover for 400 crores as a collateral for the loan.

Impact: This way risk in mutual funds will come down. Another school of thought is that the fund houses will not be able to get suitable corporations capable of giving 4x security for their loans.

Conclusion

Because of these changes proposed by SEBI,

1. Risk is coming down in debt funds
2. If Risk is low - Returns is low. The returns may come down slightly.
3. One important point we should keep in mind while investing our hard-earned money in debt funds is that, we should analyze the portfolio of the schemes, to understand where they have invested the money.

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