Regulator May Act Tough Against Undisciplined Debt Funds
Apr 02, 2019

Author: PersonalFN Content & Research Team

(Image source: freepik.com)

It seems the capital market regulator deem the decisions debt funds have made with investors' hard-earned money unpardonable. Any fund house that has compromised on strict risk management processes while lending to promoters, against securities or otherwise, are likely to find itself in hot water.

According media reports, SEBI has made some crucial observations in one of its circulars: Mutual fund schemes have investments in debt and money market instruments issued by promoter group entities which raised funds through various complex structures. These include related party transactions, corporate/ promoter guarantee, conditional and contingent liabilities, covenants, pledge and/or Non Disposal Undertaking (NDU) of shares, structured obligations, etc.

The capital market regulator has asked mutual funds to disclose their exposure to complex structures and loans to promoters through any direct or indirect form since January 2017.

Moreover, market regulator has asked mutual fund trustees to review if the schemes that have exposure to complex structures adhered to adequate risk management processes.

[Read: Is Your Investment In Debt Mutual Fund At Risk?]

What has caught mutual funds off guard?

Post demonetisation, money sitting idle in private vaults of households found a new home in banks. In the absence of the corresponding rise in bank credit demand, incremental deposits dragged interest rates.

This is when investors started preferring debt mutual funds. The inflows were so strong that mutual fund houses, perhaps, ignored the credit risks while investing in various debt instruments.

Until recently, mutual fund houses didn't realise they were relying excessively on credit ratings. Possibly, they were treating the rating of a promoter group company and that of the complex structure at par, ignoring the difference in their cash flows.

Companies such as DHFL, IL&FS, Reliance Media Works, Reliance Infrastructure, and Zee Entertainment among others were in the news lately either for financial distress or for poor governance practices.

Some debt funds failed in identifying the danger. They collectively had an exposure of Rs 31,473 crore to these companies as on 31st January, 2019.

But their actions go beyond misjudgment.

Consider this...

DHFL Pramerica invested in securities that DHFL issued which had unacceptably higher weightage in the portfolios of various schemes. For example, as on January 31, 2019, DHFL Pramerica Ultra Short Term Fund held 34.7% of its portfolio in DHFL debt.

Moreover,   DHFL Pramerica Short Maturity Fund had exposure of 14.9% to DHFL and DHFL Pramerica Low Duration Fund held 13.6% of its total portfolio in debt securities that DHFL issued.

As you might be aware, DHFL Pramerica Mutual Fund was a joint venture (50:50) between DHFL and Prudential Financial Inc. (PFI).

After the fiasco of IL&FS and DHFL, Non-Banking Financing Companies (NBFCs) became apprehensive about extending loans to debt-laden cash strapped companies. At that juncture, mutual funds came to terms with the reality.

Mutual funds also gave the Essel Group promoter Mr Subhash Chandra and ADAG Group honcho, Mr Anil Ambani, a long rope by not invoking pledges, when the value of their pledged shares dropped significantly.

According to Economic Times dated 29 January 2019,  Aditya Birla Sun Life Mutual FundFranklin Templeton Mutual Fund and HDFC Mutual Fund had invested over Rs 1,000 crore each in debt securities issued by the Essel group. Beside, SBI Mutual FundUTI Mutual FundICICI Prudential Mutual Fund Kotak Mahindra Mutual FundReliance Nippon Mutual Fund, and Baroda Pioneer Mutual Fund among others have also invested in group's debt.

[Read: Are You Holding Debt Mutual Funds With Stressed Assets?]

Perhaps, mutual funds failed to acknowledge the risks arising from the lack of liquidity and volumes. This might have forced mutual funds not to invoke pledge shares and sell off.

All the above instances suggest that, to stay competitive or to outperform, mutual fund houses often forget their mandate and become as greedy as any inexperienced investor would.

It's noteworthy that not all fund houses are making bad investment decisions. The ones following robust investment processes and systems are better off. They don't compromise on the qualitative aspects such as corporate governance to accomplish their investment objectives or stick their necks out.

PersonalFN considers all these (and many more) factors while recommending equity and debt mutual fund schemes to its subscribers.

Please remember:

  • Investing in debt funds isn't risk-free.

  • You shouldn't invest in schemes only because they have outperformed their benchmarks in the recent past.

  • You should consider your financial goalsrisk appetite, and time horizon before investing in any debt-oriented scheme.

  • Following your personalised asset allocation is the key.

  • Ideally, you should invest only in schemes that have a maturity profile resembling with your time horizon, to avoid negative surprises.

  • Last but not the least, invest only in debt schemes offered by mutual fund houses which follow robust investment processes and have adequate risk management systems in place.

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