MF WRAP: How changing FMP investment structures calibrated to their current fiasco

The mutual fund industry came into its own post the comprehensive SEBI Mutual Funds Regulations 1996 that prescribed debt and equity and derivative investments with prudential investment limits, fair valuation, and governance norms.

The initial players getting into MF business post-1996 Regulation were the financial services ones like ICICI, Kotak, HDFC and a few professional fund house like Kothari Pioneer bought out by Franklin Templeton.

The debt schemes including FMPs those days started off conservatively putting investment in long term corporate deposits (3,5,7,10 year tenures) of industry houses and bank deposits.

The question was what value addition were mutual funds providing to these quasi-bank activities of an in-between entity to investors in early years.

FMPs were mainly surplus cash deployment of corporate deposits who enjoyed indexation benefit returns investing in FMPs compared to what they would have earned had they invested directly in corporate deposits and bank deposits. These lackluster FMP days made some fund houses like HDFC MF delay their debt scheme launches by several years.

A word about indexation benefit returns. For instance: When an investor puts Rs 10,000 in bank CD gets, Rs 20,000 after five years, he pays tax on gains of Rs 10,000. In FMP when Rs 10,000 becomes Rs 20,000 on maturity, the gain of Rs 10,000 is first adjusted for inflation after the five year period.

So based on the inflation rate during the maturity period of five years, the real gains would be less than Rs 10,000, say Rs 8,500. So on maturity, the investor is taxed on the gain of Rs 8,500, not Rs 10,000.

This indexation benefit alone made FMPs attractive enough and its appeal spread to HNIs and debt investing FIIs too.

RAPID GROWTH PHASE

In came the SARFAESI Act that allowed banks and NBFCs to remove existing loans from their books, make slices of various consumer and commercial loan liabilities and transfer these future loan repayments to other entities.

MFs queued up big time to buy out these structured debts obligations from banks and NBFCs through more FMP schemes and other debt schemes.

These papers were attractive to MFs because structured debts were sliced consumer and house finance loans restructured and taken from banks and NBFCs to MFs, the returns were akin to high-interest rates on consumer loans which bank CDs could not match up to.

Banks and NBFCs had their debt obligations freed up allowing them to issue new loans to chase growth over each other.

Credit ratings also had booming business playing the referee that loan liability packets commanded what level of ratings for MFs and other DIIs to get in.

The rush for volume growth in debt investment management hotted up to an extent that equity assets started trailing debt assets under management since 2008-09.

Here was an investment class where mutual funds, did not need investing in in-house detailed analyst desks, need not be bothered with volatile Nifty/Sensex, just be in good relations with credit rating houses, get the structured SARFAESI loans rated and put FMP corpuses in that along with short term commercial papers.

Returns of FMPs cannot be promised as SEBI has banned indicative returns since 2009. But overall returns assessment is better in FMPs vis-a-vis equity because in debt papers the obligated interest returns are predefined. the limited risk is only in case of interest rate  default by risky companies in equity returns are uncertain

Still, it generated the same expense ratio for MFs as costly equity MFs without the hassle of large retail population.

EQUITY VS DEBT MEANING COST NOT VERY HIGH?

As a cost structure for fund house, FMP desk is low-cost high revenue generating business vis a vis equity desk which is high cost tight revenue-generating business. To establish equity desk, trading room, broking room, analysts desk, Bloomberg connections needed, for debt management one interest rate screen needed and trades are confirmed telephonically. So mutual funds had a general bias to promote more debt funds.

Stepped in SEBI in 2010 with a three-page piece by piece separate disclosure requirement in FMPs that these structured loans carried, according to a former SEBI DGM who worked in MF department.

SEBI halted informally FMPs unless they committed a certain minimum percentage investment in highest rated credit papers, confirmed the ex-SEBI official.

This was stemming from SEBI’s experience of MF liquidity crunch of 2008-09 when certain debt schemes failed in the sale of their debt holdings due to a lack of market for low rated papers.

In 2008, MFs were rescued on request to SEBI for a special liquidity borrowing window from RBI of Rs 20,000 crore to tide over the crisis.

Also, the debt schemes charged a higher fee to retail compared to corporate investors in FMPs wherein SEBI prevailed on fund houses to charge the same fee, if they wanted their schemes approved.

PRESENT SCENARIO

In the current scenario, post strict specific disclosures on structured loans and also that slowing consumer and auto loans lessening the plethora of such papers, MFs turned to the latest stunt of investing FMP monies into doubtful remotely held promoter companies in the supposed infrastructure space or undefined risky businesses.

SCENARIO AHEAD

With many rollovers of December 2018 and March 2019 FMPs to September 2019 for full repayment through tactical understanding with promoter companies, MFs are in muddy waters before it turns into a sinking marshy affair.

Of the total exposure of Rs 7,500 crore to the troubled entities such as Essel Group and IL&FS debt instruments, around Rs 1,400 crore is held by FMPs

The 2008-09 crisis was saved albeit after drilling some sense in MFs alongside SEBI intervention and RBI’s timely help.

This time around, the next few months would unfold whether MFs auto-correct their course or regulator steps in a big way.

Follow @HimadriBuch