Liquidity risk remains in an event of credit downgrades

Though Sebi's new debt fund investment norms address the diversification issue; industry experts say liquidity risk is a bigger risk

The Amtek Auto credit crisis affecting two of JP Morgan AMC's schemes in August last year was an eye-opener for India's mutual fund industry. It was quite an important development which underlined a hard-hitting fact that investments in debt schemes can not always be treated as safe.

The Securities and Exchange Board of India's (Sebi's) decision early this week to tighten norms for debt mutual funds is seen as an attempt to restrict repetition of such events in the future to a certain extent. The capital market regulator put caps on exposure of a scheme to debt instruments by an issuer, companies belonging to a group entity. It also put caps on sectoral exposure limits.

It was definitely a much-needed step and the mutual fund industry welcomed it. Sebi has also said that "appropriate" time will be given to the fund houses to adhere to the new proposed norms. Fund managers too have termed it as a "step in the right direction", which will help mitigate the risks by diversifying more.

However, the critical issue of liquidity risk remains. Industry experts say that the risk emanating from the non-liquid nature of several corporate bonds is far bigger and steps should be taken to address the issue.

When an corporate bond issuer is affected by a negative event, such as the downgrades of its papers, the net asset values (NAVs) of schemes having exposure in the downgraded papers lose unusually higher value in a matter of a day or two. Investors tend to redeem units in such situation. Whether exposure to papers is 10 per cent of the NAV or 5 per cent - bad sentiments affect the scheme irrespective of the exposure. If the fund house is large enough to take a hit on its balance sheet but honour redemption requests, it is fine. But fund houses that struggle even to notch up to the networth requirement of Rs 50 crore, even the repayment of Rs 5 crore from their own pockets to investors in such situation is an uphill task.

As a result, the option which is left is to "gate" the redemption or completely "stop" redemptions for a specific time as liquidity is quite poor in India's corporate bond markets. This is what happened with JP Morgan's two India-related schemes as well. 

Well, as of now, fund managers have to gear up to do step up their research and find out more investable debt instruments in order to honour Sebi's push for diversification so that the risks can be minimised.