Regulatory checks help fund houses tide over credit and liquidity crises

Holders of IL&FS papers would have faced more pain if the sectoral cap norms were not revised

Mutual funds are in a relatively better position to navigate liquidity and credit setbacks than they were a few years ago owing to a slew of regulatory changes effected in the past few years. 

“On the whole, the system has become much less risky in terms of both its liquidity and credit profile,” said R Sivakumar, head – fixed income, Axis Mutual Fund. 

The pain from holding IL&FS papers, for instance, would have been much more had it not been for the regulator’s revised sectoral cap norms, say experts. 

In February 2016, the Securities and Exchange Board of India (Sebi) restricted investments in debt instruments issued by a single issuer to 10 per cent of the scheme’s net asset value from 15 per cent earlier. The norms were revised following the default by Amtek Auto on its debt obligations in 2015. Two of JP Morgan’s schemes were invested in the company’s debt papers, with JP Morgan India Short Term Income Fund’s holding exceeding 15 per cent of its corpus of Rs 4.3 billion at the time.

The regulator has also been urging fund houses to reduce dependence on external credit rating agencies and set up their own credit teams for better due diligence. They have to periodically disclose portfolio of debt schemes and details of downgraded securities. 

“The industry has increased resources on the credit research side but it still relies on public rating. The tracking for a AAA- or AA-rated paper is typically less than lower-rated papers, and the former needs to be tracked more frequently,” said Kaustubh Belapurkar, director, fund research, Morningstar Investment Adviser India. 

“Some of the large fund houses that were able to put a strong credit process in place have been able to weather the recent liquidity crisis better than others,” added an industry official, requesting anonymity. 

Last year, Sebi’s MF advisory committee had also deliberated on making it mandatory for fund houses to form internal risk assessment committees comprising key fund officials and external consultants. The functioning of the committee was to be directly monitored by the trustees. The regulator, however, did not go ahead with making this requirement mandatory.

Source: Value Research

“The industry is still trying to learn from its mistakes. Sebi ought to draft guidelines, enumerating the size of the credit rating team along with experience and qualifications. Funds should be asked to set up a separate risk management team that reports directly to the trustees rather than the fund’s management,” said the official. 

MFs typically do not go below A-rated papers but they can technically go up to BBB, which is considered investment grade. Going below this requires permission from the fund’s trustees. Debt schemes investing in lower-rated debt papers run the risk of sudden downgrades or defaults.

Liquid funds, which primarily invest in money market instruments like certificate of deposits, commercial papers and term deposits, have become less risky as well. 

After 2013, several funds are putting their liquid funds to periodic stress tests to gauge the impact on these schemes in case of sudden redemption pressure or significant changes in credit quality. 

This was done after several large liquid schemes saw significant outflows after the RBI raised short-term rates to defend the rupee in July 2013. 

Until 2009, liquid funds were allowed to hold one-year papers and even invest in papers exceeding the tenure. Now, they can only invest in securities with a residual maturity of 91 days or less. Reduction in tenure of papers has significantly reduced risks associated with these funds, said experts.