The Securities and Exchange Board of India (Sebi) will soon issue a clarification to mutual funds (MFs) over the treatment of corporate defaults, particularly because of the stoppage of economic activity, after the fund houses approached the regulator in this regard.
The move comes in the wake of rising redemption pressure, lack of activity in the bond market and fears of non-payment of dues by corporate houses because of the shutdown in business activity. Some players have highlighted that they have had to borrow or liquidate high-quality paper — raising concentration risk — to meet the redemption pressure.
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“We are examining the challenges faced by the MFs and working on a possible solution. The regulator has been consistently putting in place several regulations to reduce such risks associated with sudden event and would continue to issue guidelines as and when required,” said a regulatory source. The MF industry has been reeling under stress over delays in repayments and defaults by companies, particularly non-banking financial companies (NBFCs) amid the lockdown imposed to curb the spread of the coronavirus disease (Covid-19) pandemic.
At present, most debt fund categories do not have restrictions on the amount of credit risk they can take. Sebi’s clarification on treatment of defaults would allow MFs to hold securities without selling in the open market after default, said the source cited above.
In March, debt schemes witnessed sharp redemption because of sell-offs in markets in view of the lockdown. The industry saw net outflows of about ~1.94 trillion from the debt schemes in the month.
Experts say that measures like a moratorium are being discussed. However, they might be untenable for the MF industry, which manages pooled assets, with many investors moving in and out on a daily basis. Industry players said side-pocketing is a more viable option.
Last year, Sebi allowed debt MFs to separate bad assets from the other liquid investments to safeguard existing investors. “MFs are not banks, so any moratorium would not be viable. If huge redemption happens in scenarios like this, investors can’t be asked to wait for three months to exit. So, if the illiquidity is sudden, side-pocketing provision can be enabled allowing bad securities to be separated from good ones,” said Dhirendra Kumar, founder of Value Research.
“The law is clear that fund houses have to enforce security on default. And if required they can opt for segregation of portfolio provision,” said a member of Amfi. Sebi has time and again tightened norms for debt funds, including on liquid funds, to protect investors from credit and liquidity risk. These changes have come in the aftermath of IL&FS default, which turned lenders cautious about NBFCs, resulting in a credit squeeze.