Explained | How Sebi’s new rule makes NAVs of debt schemes grounded in reality

Why did Sebi feel it is important for rating agencies to give valuations of debt securities that get downgraded to below investment grade?

Before we answer this question, let us first understand the role of credit rating agencies here in the first place.

Your mutual fund’s net asset value is a reflection of its underlying portfolio. If the prices of the underlying securities rise, your NAV goes up and vice versa. Since the debt market is illiquid, not all securities get traded on a given day. Hence, two rating agencies, Crisil and ICRA are given the task of giving out valuations of all the debt securities where the debt funds have invested. They collate these prices daily and send the list to all mutual funds, as per the Association of Mutual Funds of India’s (the mutual fund industry’s trade body) mandate. Debt funds refer to these prices and then compile their NAVs.

But rating agencies provide prices of only those securities whose credit rating are up to the investment grade (‘BBB’). Now, Sebi has said rating agencies to provide the new values of securities also where the rating has been downgraded to below investment grade. Hence, there will now be uniformity in the way such securities will be marked. Your debt funds’ NAV will now be more realistic, irrespective of whether your debt fund is aggressive or conservative. This is good also because debt securities are valued by external agencies; there is objectivity.

But wasn’t this happening earlier too? The rating agencies were giving values of debt securities earlier too. How have debt funds become more realistic?

Up until now, the rating agencies were providing the values of all debt securities, rated as well as unrated. But once the security’s credit rating fell below investment grade rating (‘BBB’ rating), the rating agencies stopped supplying their values. Then, the internal valuation committees of the fund houses took over. Each individual fund houses’ valuation committee decided by how much the downgraded security needed to be marked down.
There was a small loophole here. Fund houses could individually decide by how much the same security needed to be marked down. One fund house could mark it down by 25 percent, another could mark it down by 50 percent, yet another could be conservative and mark it down by 75 percent. But with the rating agencies set to provide values of all such securities, there will be uniformity in the way your fund arrives at its NAV.

Is that the only measure that Sebi announced that would make the debt funds’ NAV more realistic?

No. Sebi also announced that all securities that mature beyond 30 days will need to be marked to market. Earlier, this limit was 60 days. Securities that mature up to 30 days will continue to be amortised. In other words, if your fund holds securities that mature after 30 days, its price would be marked to market. To that extent, your debt fund would be more volatile because its NAV would move up and down more in sync with how debt markets move.

Does that mean my debt fund will get more volatile going ahead?

Not quite. Although Sebi has reduced the mark-to-market requirement from 60 days to 30 days, it won’t impact many liquid funds. This is because most liquid funds already hold securities that mature much sooner than 30 days. These funds will continue to amortise their securities like they used to before. In simple words, if the money market instrument (in which your liquid fund invests in) is issued at Rs 93 and the face value or maturity value of it is Rs 100, then the difference of Rs 7 is the interest amount that is due to your debt fund. This gets accrued to your liquid fund equally through the tenure of the instrument. Hence, the liquid fund’s NAV moves up in a linear fashion.