Ever since the unfortunate FT (Franklin Templeton) episode broke out, investors are naturally disturbed and discussions are centred on the role of regulators and the ethics of the business house. However, given a choice, no business house would like its goodwill to go to dust and no regulator would like an entity to be in trouble, as investors have to bear the brunt. Instead of spending more time on what has already been discussed, let us take the learnings from the event.
Learnings for Investors
Return-chasing as an objective has to be considered carefully. While depositing money in banks, we look for higher interest rates. While investing in debt mutual funds, we look for a higher portfolio YTM (yield to maturity). When we buy bonds, we look for ones with higher coupons or interest rates. This is not to say that any instrument with a higher rate of interest will default; it has to be seen in perspective. For the so many debt MFs that have suffered defaults in their portfolios, and some have given negative returns, there are a few real estate AIFs (alternate investment funds) that carry a relatively higher risk, but have matured and given handsome returns to investors. A bank is supposed to be sound, taking good care of depositors’ money and supervised by the regulator. A bond with a high credit rating is supposed to be safe. But the point is, you have to know what you are getting into.
As long as the going is good and business/industry cycle is on the upswing, everything seems hunky dory. When the real estate sector is booming, products maturing in the bull phase will fetch you good returns. When the industry is in a dull phase, there would be unsold stock and returns will be muted. A bank giving a higher rate of interest than another bank means it is more desperate for funds. If the regulator misses the loose link, then the rope will break. PMC (Punjab and Maharashtra Cooperative Bank) created thousands of fictitious accounts and disbursed relatively smaller amounts of “loans,” as larger accounts would attract the attention of the auditors. The RBI missed this detail and the bank went bust. In debt mutual funds, when the economy is in a buoyant phase, defaults are on the lower side and the impact of default risk is not apparent. When defaults start, we realize that such a risk is present. It was always there; it is only that we did not realize it.
The moot point is, when you opt for something “higher,” i.e., interest rate or portfolio YTM, you are not opting for the second or third best option, which may be relatively safer. Still, if you are convinced about the “higher” option, go for it. In the case of FT’s debt funds, the portfolios are available for all to see, and the YTMs are there to compare.
Lessons for SEBI
Even though SEBI is clear about the approach to mutual funds, that it is a vehicle for investment in the markets and bears the concomitant risks, this event is worth pondering. The fund categorization guidelines are anyway due for review. Out of the sixteen debt fund categories, only two have a mandate on credit rating. In corporate bond funds, 80 per cent or more of the portfolio has to be invested in securities rated AA+ / AAA; for credit risk funds, 65 per cent or more has to be in papers rated AA and below. In other debt fund categories, it is open to what is mentioned in the Scheme Information Document (SID) and the fund manager’s decision. This is fair from the fund manager’s independence point of view. However, categories such as ultra short term are perceived by investors as being “just next to the liquid category.”
In ultra short or low duration categories, subject to what is mentioned in the SID, the fund manager can take exposure to papers rated below AAA. This is not to say that below AAA means default candidate, but to indicate that the boundary should be defined by market regulator SEBI. Whether the limit for investment in less than AAA instruments in ultra short term should be 100 per cent or 20 per cent needs to be debated by the SEBI management.
The other aspect is maturity of individual papers. In the liquid fund category, it is defined as a maximum of 91-day residual maturity for any security in the portfolio. In other categories such as ultra short or low duration, it is defined in terms of the average duration of the portfolio. This means, one (or more) single instrument in the portfolio can be of significantly longer maturity, as long as the weighted average is within the defined range. In the ultra short category, the average has to be in a range of 3-6 months. The issue is, to the extent of longer maturity papers in the portfolio, the risk goes up, which is known by the jargon “barbell” in the industry.