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Lessons from recent events in the mutual fund debt market

The month of October 2008 has seen unprecedented news about debt schemes of mutual funds; some of it factual, some of it speculative. In this article the author places the events in perspective and suggests long term measures that may be needed to set the debt funds on a sound footing.

As a natural evolvement towards sharper returns on debt funds, mutual funds launched "Liquid Plus" schemes and then "Fixed Maturity Schemes" (FMP). Liquid Plus schemes sought to improve yields over Liquid (Money Market) Funds by having some investments in corporate securities. The thinking perhaps was that the "core" or long-term liabilities, that is that portion of the assets of the scheme which represented a floor, could be profitably invested in longer term paper that yielded higher returns. "Prime Funds" in the U.S. also evolved in the same manner.

In hindsight, the strategic error was in thinking that the level of "core" assets would not be breached, would always be salable, and would represent, in aggregate, a "perpetual" investment floor. No restrictions were imposed on liquidity of the units that reflected the potential illiquidity of these "core" assets. Fixed Maturity Plans carried this thinking a step further by attempting to match the duration of the liability to that of the asset. By essentially holding the securities to maturity, it was possible to mitigate the effect of midterm mark-tomarket effects and reasonably assure the yield.

Here again, though the product was launched with the expectation that investors would hold to term, there was no actual restriction on redemptions. Furthermore, fund managers started investing in securities of a longer term than liabilities, in the expectation that the liabilities would be rolled over on maturity. Both these set the stage for difficulty in the event of premature redemptions.

Environmental issues caused by events outside of India caused market liquidity to contract sharply, thus forcing corporate investors in Liquid Plus and even FMP investments to seek redemptions. Because of the tightened liquidity, the Funds could not sell their investments in time, at a fair price, and in some cases at all, and therefore had issues with meeting redemption payment obligations. Somewhere along the road, media speculation about quality of investments held by mutual funds also made that issue far larger than it really was; and this was another contributor to redemptions.

Liquidity window

The Reserve Bank of India opened a liquidity window to fund MFs against bank certificate of deposit (CD) collateral; however the effective interest rates were in excess of 15 per cent against fund yields of 10 per cent to 11 per cent. MF regulations require that excess interest costs be absorbed by asset management companies (AMCs).

Due to overwhelming volumes of redemptions, MFs had to borrow huge sums of money. In most cases securities could be sold subsequently in an orderly fashion to pay back the loans. However some securities were illiquid either by design or because of a drop in issuer perception, and could be only sold back on maturity. AMCs thus had to carry the funding on their books and be on the hook for interest rate differential costs for relatively long periods.

Redeeming investors are given NAV based on the timestamp of their transaction, which normally reflects the previous day's market prices. In a sharply volatile debt market, the price realisable by a scheme would in many cases be lower than the previous day's price, thus creating a gap which needed to be met.

Regulators' quick move

Anecdotal information suggests that some AMCs have protected schemes' NAV by taking these costs on their own book, and continue to be on the hook for future costs. They have done this because loading these costs on the scheme was either prohibited by regulation or because a sharp difference between expected returns and actual returns would likely have impacted the AMC negatively in the market and made future asset gathering difficult.

Regulatory support to mutual funds in this period has been nothing short of outstanding. There has been a pulling together of monetary and capital market entities, and there has been none of the usual public blame game. The focus has been strictly on overcoming the crisis by cooperative action. There is across-the-board acknowledgement of the extraordinarily responsive role of regulators.

In the short term, the RBI had responded by making available a liquidity window; it requires collateral of bank CDs and not corporate paper. There seems to be a high spread that commercial banks are charging on this lending and it was only with high level intervention that "fair" interest rates were implemented. The Securities and Exchange Board of India (SEBI) has newly allowed significant discretion to fund managers on less-traded debt security valuation; the expectation being that FMP investors who exit midstream will receive a low NAV based on realistic valuations.

Investors have understood that though all schemes are labelled as "Liquid Plus", they do differ substantially in risk assumption. In general, there has been a flight to safety from smaller funds and newer entrants. While investors may ultimately return to Liquid Plus schemes, FMP schemes will take a long time to recover. The impact on industry is illustrated by the non-equity assets under management (AUM) figures.

In the long term SEBI has expressed a desire to review the framework under which debt mutual funds are issued. Amongst the thought processes are, a greater alignment of duration of securities to the character of the scheme, that is, liquid funds will invest a greater proportion in very short term paper; restrictions on redemption in fixed maturity plans and the like. Whatever the investment side restrictions that are imposed, it is the author's view that they will not be long term solutions. Liquid Funds, in fact, have always been well managed; and it was Liquid Plus Funds that sought to give investors the cake and let them eat it too. Such products evolve out of the fierce competitive spirit amongst AMCs, and an excessive topline focus as opposed to a balance between topline and bottomline.

Excessive focus

The excessive focus by AMCs on topline (or rather Assets under Management) has resulted from a few headline grabbing sales of AMCs where the valuation was based on the AUM rather than on conventional metrics such as profits. Many AMCs started shifting focus from profits to valuations as their interest in "the game", and thus compelled even other "normal" AMCs to follow suit. The recent fall in market capitalisations would hopefully focus AMCs back to the basics of building a good business in the traditional way.

Liquid Funds are currently used by corporates to deposit short term money and earn 7 per cent or so even for 2-3 days, which money would otherwise have earned zero per cent in a current account. The benefit to a corporate investor is therefore not really the tax arbitrage between dividend tax (at 28 per cent) and income tax (at 34 per cent), but rather the existence of an income at all for monies of these short durations. When a liquid fund offers such a vast benefit, there is no reason for AMCs to short-change themselves by not charging a fair management fee. Fees for fixed maturity plans are anecdotally said to be even zero, that is, an AMC makes no money at all on the scheme, whereas there is obvious risk to reputation and finances as was demonstrated in October.

Over-reaction

One other concern is of regulatory over-reaction; at this stage the industry is in a very fragile stage. While certainly some change in regulation is desirable, we must understand that a short-notice drawdown of 25 per cent of assets of any fund based business is like a tsunami; it speaks highly of the mutual fund industry that the industry collectively was actually able to repay such a large sum in such a short time. It speaks highly of AMCs that so many of them placed their investors' interest above their shareholders' by absorbing many losses that could have rightfully been passed on to investors. It is a matter of conjecture as to how the nonbanking finance companies (NBFC) or banking sectors would have responded to such a massive drawdown of assets. Yes, mutual fund regulation must change, but only after enough time has passed for shell-shocked AMC management to be able to rationally examine the required changes. Indian mutual funds, on the whole, are a well regulated and ethical class of intermediary.

Yes, some mistakes were made in the past, but the author believes that the industry has learnt its lessons well from this crisis and deserves strong support from investors and regulators alike.

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