Sebi asks asset management companies to explain bond investment rationale

Mumbai: The capital market regulator has asked asset management companies to explain the principle behind their corporate bond investments, as it seeks to avoid a redemption crisis in the fixed-income plans of mutual funds (MFs) similar to the one JP Morgan Asset Management Co. Ltd is battling.

In a cautionary note issued to fund houses, the Securities and Exchange Board of India (Sebi) also asked fund managers to closely monitor companies in their mutual fund portfolios that have been downgraded recently, two people familiar with the note sent out by the regulator said on condition of anonymity.

The advisory follows the hit taken by two JP Morgan schemes that had Rs.193 crore of exposure to bonds of auto components maker Amtek Auto Ltd, which were downgraded by rating agencies because of the company’s deteriorating financials.

As a result, the fund house was forced to restrict redemptions from the two schemes. On Monday, JP Morgan proposed to split units in these schemes into two—one for Amtek Auto securities and the other for all its other investments. The fund house said it would accept redemptions from the latter if unit holders vote in favour of the proposal.

The episode has raised red flags over increasing corporate debt investments by domestic mutual funds. Mutual fund investments in corporate debt through short-term and corporate bond funds have risen tenfold from Rs.13,945 crore in the fiscal year ended March 2009 to Rs.1.4 trillion in March 2015, Mint reported on 24 August, citing data from mutual fund tracking firm Value Research. At present, India has 44 asset management companies (AMCs) with total assets under management (AUM) of Rs.12.28 trillion as of the end of June.

By asking funds to explain the rationale of corporate debt investments and monitor such investments closely, Sebi is trying to tackle any risk that may emerge for investors in debt schemes.

“Sebi wants AMCs and their trustees to avoid taking too much risks for their investors while investing in bonds of companies that may have undergone rating downgrades in the recent past. Sebi has also asked fund managers to explain the principle behind all their investments in such debt papers,” said one of the two persons cited above. This person heads one of the top AMCs in India.

Sebi did not respond to an email sent by Mint requesting comment.

At present, while Sebi norms require regular monitoring and assessment of credit risks in close-ended schemes of mutual funds by their trustees, there is no such explicit regulation for open-ended schemes.

The redemption crisis at JP Morgan AMC has highlighted the need for closer scrutiny of open-ended schemes as well.

In a closed-ended fund, investments can be made only during the new fund offers (NFOs) and no new investor can apply to buy mutual fund units once the offer closes. These funds have a fixed tenure, and investors can liquidate their investments only on maturity.

An open-ended scheme is one in which the tenure is not fixed, and inflows and outflows of money are a constant feature.

The money that comes into open-ended schemes is short-duration money and, hence, chances of a significant liquidity risk emerging are lower than in the case of close-ended funds, said the first person cited above, explaining the rationale behind closer monitoring of closed-ended schemes so far.

Over the past year, listed companies whose bond ratings have suffered steep downgrades include Amtek Auto, Jindal Steel and Power Ltd, Jaiprakash Associates Ltd, Bhushan Steel Ltd and Bhushan Power and Steel Ltd, among others, according to data released by rating agencies.

According to Value Research, the mutual fund industry has an exposure to corporate bonds of at least 275 listed companies.

At Rs.13,177.88 crore, Franklin Templeton Mutual Fund has the highest exposure to corporate bonds. This is followed by HDFC Asset Management Co. Ltd with an exposure of Rs.12,563.19 crore, and ICICI Prudential Asset Management Co. Ltd with an exposure of at least Rs.6,043.57 crore, according to Value Research. Birla Sun Life Asset Management Co. Ltd has exposure of at least Rs.3,891.87 crore to corporate bonds, shows the data.

Given the considerable exposure that funds now have to corporate debt, regulations must be tightened, said Dhirendra Kumar, chief executive officer (CEO) of Value Research.

“Sebi must overhaul the existing regulations on the exposure limits taken by an open-ended scheme. The 15% cap on exposure is not enough to address the liquidity risks that a fund house may take through open-ended schemes and the impact it may cause both to the investor and the fund house. Sebi should change the rules,” said Kumar

According to current regulations, an open-ended mutual fund scheme is allowed to park up to 15% of its money in debt issued by a single company.

Kumar suggests that the regulator fix a percentage cap on exposure of an open-ended scheme to illiquid securities.

“For instance, Sebi may stipulate in its new rule that an open-ended scheme can have a maximum exposure of 20% in illiquid securities at any given time, and once the exposure in illiquid securities crosses 20%, the scheme automatically becomes an interval fund, which is a partially close-ended and provides free entry and exit to investors only at certain intervals,” Kumar said.

The sales head at one of the top 10 AMCs also said a change in rules is necessary and suggested a cap on sectoral exposure.

“There definitely has to be a regulatory change on exposure norms. Instead of just having a 15% cap on exposure in a single company by an open-ended scheme, Sebi may think around sector-wise exposure limits that an open-ended scheme can take to manage liquidity risks,” this person said on condition of anonymity as he is not authorized to speak to the media. This person isn’t one of the two people cited in the first instance.

At present, open-ended schemes are valued on the basis of the value and ratings of the debt paper they invest in.

The debt is valued as per the valuation metrics assigned by credit rating agencies. While evaluating debt paper, credit rating agencies consider a number of parameters, including the issuing company’s ability to pay debt, ratio of debt to equity, cash flows and income the issuing company earns from the projects for which debt has been raised. Macroeconomic fundamentals are also taken into account while rating these companies.

The daily net asset value of open-ended schemes, calculated on the above valuation and rating criteria of debt securities, is communicated at the end of every day.