Sebi's new norms will ensure uniformity in valuation of high-risk papers

But the issue of how much credit risk different debt fund categories should take remains to be addressed

Continuing with its reforms of debt funds in the wake of the IL&FS defaults and downgrades, the Securities and Exchange Board of India (Sebi) has announced new norms for the valuation of below-investment-grade debt securities. These new norms, say experts, will bring uniformity in how debt funds value such securities. 

Earlier, when rating agencies downgraded a paper to below investment grade, there was no uniformity in how fund houses reacted. “Every fund house took a different level of haircut (or mark down) and on different dates,” says Dwijendra Srivastava, chief investment officer, fixed income, Sundaram Mutual Fund.

Until now, rating agencies provided valuations for investment-grade securities only. “Now they will have to provide valuations for below-investment-grade papers as well,” says Vidya Bala, head of research, Fundsindia.com. 

Mutual funds typically do not hold below-investment-grade securities, barring when the securities in their portfolios get downgraded. These securities will now be valued in accordance with the valuations provided by agencies like CRISIL and ICRA. Suppose a security is valued at Rs 102 in the portfolio. After a downgrade, these agencies may decide that the security will not fetch more than Rs 90 in the market. All asset management companies (AMCs) will then have to take a uniform haircut of Rs 12. Earlier, one AMC may have thought it would be able to get a valuation of Rs 90, and hence valued it at that level, while another may have valued it at Rs 95. “There will now be consistency across fund houses in how these papers are valued,” says Srivastava. If a fund house wants to veer away from the valuations provided by the agencies, it will have to record the reasons for doing so, present them to its board of trustees, and inform investors.

Till the agencies are able to come up with the final valuation of such a paper, they will have to provide indicative haircuts. On the very day they announce a downgrade, they will have to state how much initial haircut AMCs must take. “This is the valuation every fund house will have to adopt until the agencies come up with the final valuation,” says Bala.

Suppose some trading happens in the downgraded paper. If the price at which trading happens is lower than the valuation provided by the agencies, then fund houses will have to mark down these papers further to the traded price. If the agencies stated a valuation of Rs 90, and that paper gets traded at Rs 85, AMCs will have to mark it down to Rs 85. However, Sebi has said the traded price will be used only for valuation purposes if a certain minimum volume of trade takes place (which it has yet to specify).

Experts say while these norms take care of the ad hoc manner of valuing below-investment-grade papers, the risk of investing in debt funds remains the same. “Sebi's categorisation exercise only stated how much duration risk different categories of debt funds can take. Except in the case of corporate bond funds and credit risk funds, Sebi did not stipulate the level of credit risk different debt fund categories can take. As a result, you have even short-term debt funds taking a high level of credit risk,” says Bala. She adds either the regulator should specify the level of credit risk fund houses can take in different categories, or fund houses should actively disclose the level of credit risk they have taken in a fund. Until these changes happen, investors will have to watch out for this risk themselves.