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Sebi action has made debt
October, 05th 2009

It's been a year since the debt funds came under increasing redemption pressure and the Securities and Exchange Board of India (Sebi) issued a slew of new regulations. Of the entire debt funds segment three product offerings -- liquid, liquid plus (better known as ultra short term) and Fixed Maturity Plans (FMPs) -- came under significant pressure.

We did a before and after scenario check and the finds are given hereunder.
Sector allocation
In September and October of 2008, it was not unusual to find asset management companies going on record to say that the portfolios of their schemes held no exposure to real estate companies. Before the crisis erupted, no one paid heed to high exposure levels because the aggregate exposure for the entire debt segment based on portfolios released at every month end, never did in the first place show a significant allocation to realty firms largely driven by high AUM valuation.

However, there were specific schemes where 20-65% of assets were invested in the debt obligations of real estate companies. Some of the funds drastically cut down their holdings to a smaller one digit percentage within a month's time and couple of the reductions was startling which showed rapid downselling. The fear of investors was not without reason for almost all real estate developers have used the lifeline allowed by the Reserve Bank of India to restructure their loans as they were hit by slowing sales and mounting debt.

In February 2009, DLF, the country's largest realty company, refinanced about Rs 2,000 crore loans at a 12-13% interest rate out of the Rs 4,300 crore it needed to repay by June 2009. The company now plans to raise the remaining Rs 2,300 crore from selling bonds, discounting lease rentals and selling stake to private equity investors. The real estate sector being the worst hit in the crisis, many of the others were affected in varying measure, most of them being very significant.

Last year's experience has taught AMCs a lesson in favour of prudent diversification; as of today the maximum allocation by a debt scheme to a real estate company has drastically reduced to 15%. These high exposure levels were more concentrated in the liquid and ultra short-term or liquid plus funds and fixed maturity plans (FMPs).

Another sector which comprised f non-banking finance companies (NBFC) also came under the scanner of investment managers. Any financial crisis does affect all players in varying measure and NBFCs were affected in high measure, also because of their high exposure to the realty sector.

Since then of course NBFCs have managed to salvage the situation with RBI's liquidity lifeline. Before the crisis, it was not unusual to find anywhere between 10% and 20% of the debt assets invested in NBFCs, however this exposure began to ease of gradually, and today only about 6% of the debt fund assets are invested in NBFCs. There are of course schemes that continue to aggressively invest and believe in this sector being a useful intermediary in credit distribution.

Instrument allocation
Another segment where debt mutual funds invested aggressively were securitised debt instruments. The reason why securitised debt instruments came to be shunned by investment managers was due to the illiquid nature of these instruments, as some of the companies, especially real estate and NBFCs, which had issued these papers, had defaulted in payment of their loans at the time of maturity and rapid credit downgrades.
An analysis of the instruments that were included in the portfolios shows that the allocation to such instruments peaked at the time of the crisis and stood at 13.96% in October 2008.

Here again the concentration of holdings is more amongst the fixed maturity plans, which do not actively trade in such papers and rather hold them to maturity. Now in such a case where the aim is not to sell these securities, low trading volumes or inability to offload such instruments in the secondary market should ideally not create a problem.

However, the problem still cropped up because AMCs stood ready to liquidate such papers to enable them to handle redemption pressures from investors with the result that there were distress sales, which in turn affected unit NAVs significantly in cascade. Therefore, the illiquidity in trading became a very serious issue with mounting redemption pressures.

Whilst the concept of holding to maturity is beneficial, the ready liquidity offered by AMCs posed a problem in terms of asset liability mismatch when investors redeem in panic. Something similar to what would happen to a bank if all the account holders were to ask for their cash on a particular day when monies are invested in long-terms assets, say a power plant which has a long gestation period. This aspect needs to be also understood by an investor.

Sebi then came to correct this aberration when it made FMPs strictly close-ended and made it mandatory for these FMPs to be listed. As a result, the unit holders can trade in their units in an exchange to make them liquid whilst ensuring that asset liability mismatch is avoided as far as the fund is concerned. FMPs are today back to aggressively investing in such papers. However, since the last year's fiasco, liquid and ultra short-term debt funds have reduced their allocation in securitised debt instruments from an average of 13-15% to a mere 2-5% today.

Sebi moves in rescue of mutual fund
Sebi, to introduce discipline and better investment practices, decreed that if a debt fund is close-ended, the mutual funds must not repay its investors prematurely. This is for the obvious reason to save these funds from running into liquidity problems. Also, looking at the inconvenience of the investor, Sebi decreed that all such funds should be traded in the market. This met the twin-pronged objective.

Apart from the mandatory listing of FMPs, Sebi also set right the fears of an asset-liability mismatch. Fund managers would have to structure their portfolio by buying assets that will mature along with the tenure of the scheme so that there will not be mismatch between tenure of the scheme and maturity of the holdings under the scheme.

Added to this, in the interest of investor protection and awareness, disclosure of portfolios of FMP schemes became mandatory. The regulator prescribed a format within which AMCs are now required to reveal even the underlying exposure of their securitised instruments.

Further, Sebi also put a cap on maturity of the papers that liquid funds hold to three months in order to ensure that the schemes invest on the same lines as investor expectations. Mutual funds were also banned to declare indicative returns and yields under FMPs, which according to Sebi is misleading to the investors.

Apprehensions of regulations
After the new Sebi norms, marketers predicted that FMPs would cease to exist. Also, the cap put on the duration of papers that liquid funds could invest in was predicted to reduce the returns considerably.

As expected, assets under FMPs reduced to Rs 39,359.96 crore in February 2009 relative to the Rs 98,688.94 crore managed in September 2008, which is a decrease of more than 60%. But one year on, the FMP product is back in the reckoning as the most popular mutual fund product. However, the news on liquid funds is not as encouraging.

The returns on these funds have indeed reduced drastically. As predicted, the returns under liquid funds fell from annual 8.36% on December 31, 2008 to annual 5.74% as on September 30, 2009. But we consider this as a positive development, because 'liquid' was a misnomer for the category and the high returns defied the risk-reward equation. This was primarily because these funds were not being strictly managed as 'liquid' funds. In September 2008, it was not unusual to find a liquid fund maintaining an average maturity of more than one-year as well. The average maturity maintained by liquid fund at the end of September 2008 was 147 days, as of August 2009 this has reduced to 28 days.

Thanks to the timely action by the regulator, debt schemes look trimmer and are working more efficiently today. With better disclosures in place, investors are also better informed to make timely redemption decisions.

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