Six schemes of Franklin Templeton Mutual Fund have been ‘shut’ i.e. closed for purchase or redemption, and the fund manager will gradually sell the assets in the schemes and return the money back to investors.
Now the smaller question is how did it happen and the bigger questions are what you should do now and what should regulator, AMCs and distributors do to ensure best practices in future.
Starting with the small issue first. There was redemption pressure, more so with one particular fund house as they had a higher exposure to ‘risky’ debt instruments. We can debate what is risky but to keep life simple, let’s say instruments rated less than AAA or less than AA are risky.
As per regulation, an AMC can borrow up to 20% of its assets to meet redemptions. To compound matters, bond market was tight, liquidity was low and yields were high in March. Hence, instead of selling bonds at high yields, the fund house chose to borrow. Market situation improved in April by virtue of RBI intervention but redemptions continued. As per regulation, AMCs have to honour redemptions. That means, the fund house was forced to sell the relatively better instruments in the portfolio, effectively increasing the proportion of the relatively inferior ones. They took the drastic call of gradually winding up six schemes, so that those who exit early do not get a “better” exit and those who don’t are left with a relatively inferior portfolio.
What should you do?
It may sound like stating the obvious but you should not panic. There is nothing wrong with the debt market structure or the financial system in India. If anything has changed, it is due to the pandemic and people not being able to work normally, certain cash flows have been hampered. This has given rise to apprehensions that there may be incidences of default, particularly in the NBFC sector. However, the government and the RBI have been proactive and supporting industry and markets. Even if there are issues, the solution is not to redeem from debt mutual funds. In the mutual fund industry, majority of the assets are in better quality papers i.e. AAA rated bonds or government securities or treasury bills or bank CDs. Only a certain exposure is in NBFC bonds or commercial papers, that too in the relatively better ones.
The “social distancing” you should do for your clients is to recommend better quality debt schemes and avoid credit risk. In this context, better quality means funds with higher exposure to AAA rated bonds or government securities or treasury bills or bank CDs. This is not to say other exposures are bad; this is till such time we get clarity on the impact of the pandemic on our economy, on how soon we come back to work, how soon the wheels of the economy start moving and cash flows normalize. By then, we would get a perspective on the apprehensions about NBFCs.
What should the system do?
While the government and the RBI have been supportive, the impact is visible more on government security yields (10-year yield is at 6.1%) and surplus liquidity in the banking system (banks parking Rs 7.1 lakh crore with the reverse repo liquidity adjustment facility of RBI). What is required is something to address the crisis of confidence in the NBFC sector. This can be addressed by the RBI, through opening of a special credit line for NBFCs. There is a precedence on this; in 2008, subsequent to the global financial crisis, the RBI opened a special credit line for NBFCs.
SEBI has already given a relaxation yesterday, incidentally the same day as the news of FT AMC broke out, on valuation and defaults for mutual funds. The circular says “If the valuation agencies appointed by AMFI are of the view that the delay in payment of interest/principal or extension of maturity of a security by the issuer has arisen solely due to COVID-19 pandemic lockdown and/or in light of the moratorium permitted by RBI . . . creating temporary operational challenges in servicing debt, then valuation agencies may not consider the same as a default for the purpose of valuation of money market or debt securities held by mutual funds.” That is, CRISIL and ICRA are allowed to go a little easy on the definition of default for valuation purposes, as it would accentuate the problem.
From product manufacturers point of view, they should go easy in terms of taking exposures that may have a liquidity impact cost. Credit assessment is about the probability of the issuer paying back the money. Liquidity assessment is a different context: the issuer may pay back on maturity but if it is required to be sold in the secondary market in the interim, there is an impact cost attached to it i.e. trading of securities lower than its valuations due to liquidity concerns.
There is a delicate and subjective issue about the fund’s sponsor or the business house it belongs to. Like we discussed above, the fund manager should look at not only the credit quality of the instrument, but the acceptability of it in the market. Just in case something goes wrong, like the case we are discussing, what is the acceptability of the “name” of the sponsor / business house among investors in general? If the name is comfortable then the fund is unlikely to face a run.