Stricter norms for share-based lending, higher cash holding in portfolios, restrictions on investing in listed debt instruments were important announcements
Market regulator SEBI (Securities and Exchange Board of India) announced a slew of measures to tighten the norms governing the mutual fund (MF) industry. The MF industry has been reeling under stress caused due to delays in interest, principal repayments and, worse, defaults by companies that schemes had lent to.
Liquid funds: more liquid, stricter NAV norms
The net asset value (NAV) of a liquid fund, at which you get to buy and sell your schemes, is set to get more realistic. Sebi has mandated that the entire portfolio of liquid funds should be marked to market. In March, Sebi had said that all securities in a liquid fund that mature beyond 30 days will need to be marked to market. Earlier, this limit was 60 days. Securities that matured within 30 days were amortised. However, Sebi was worried about how realistic the liquid funds’ NAVs really were.
“This is a pre-emptive measure but it makes the NAV more realistic. Because a liquid fund’s NAV used to move, more or less, in a straight line on account of amortization method of valuing securities (those that mature within 30 days), it didn’t show the actual volatility,” says Dhirendra Kumar, chief executive officer, Value Research, a Delhi-based mutual fund research firm. Kumar added that liquid funds would become more volatile, going forward, “but not massively volatile.”
Further, Sebi wants liquid funds to be more liquid. To ensure that fund houses are able to liquidate their portfolios fast enough to meet redemption pressure, Sebi has now mandated that liquid funds have to invest at least 20 per cent of their portfolio in liquid assets such as cash, government securities, treasury bills and repo instruments. Also, liquid funds can now invest only up to 20 per cent in a single sector, down from 25 per cent earlier. Additionally, liquid funds cannot invest more than 10 per cent in housing finance companies (which is over and above the 20 per cent single sector restriction), down from 15 per cent earlier.
Sector limits set, quick exits made expensive
The sector limits for the remaining categories of debt funds shall continue as per the old limits—25 per cent for a single sector and 15 per cent in housing finance companies.
“Sebi has observed that many large investors of liquid funds used to exit funds within a day or two or within seven days. This, despite liquid funds being allowed to invest in securities that mature up to 90 days. A graded exit load structure will need to be put in place by liquid funds to penalize premature withdrawals before seven days. This is done to bring about more stability to liquid funds”, said Ajay Tyagi, Chairman, Sebi.
All debt funds must also now mandatorily invest in listed debt securities like non-convertible debentures and commercial papers. This, Sebi said, would be implemented in a phase manner to ensure that fund houses will not be required to sell a large quantity of their existing unlisted debt securities that may have been invested.
Debt funds to face tighter lending norms
Mutual funds that lend to corporates against pledged equity shares will now have to insist on a cover of at least four times.
Earlier this year, debt funds came undone when the share prices of some Essel group companies fell in January. Many mutual funds had lent to the Essel Group against shares pledged by these companies. The security cover for all lending by mutual funds in this arrangement was around 1.5 to 1.75 times. In simple words, if a mutual fund lends Rs 100 to Essel group, the group would pledge shares worth Rs 150-175 with the mutual fund. If the share prices were to fall below this limit, then the borrower (Essel Group in this case) would make good the loss by paying cash to the fund. If not, the fund house starts selling shares to recover cash to protect itself against a further slide in share prices.
However, the cover fell fast and furious when the share prices of the company fell. Instead of selling the group companies’ shares or demanding additional cover, fund houses gave a reprieve to the Essel group to repay its debt by September 2019. Sebi has come down on both these practices.
First, it has now increased the mandated cover manifold.
Second, by specifying and mandating a minimum cover, fund houses will now have to compulsorily sell their pledged shares and recover the money from promoters if the company’s share prices fall. This, as we said above, did not happen in the Essel Group case even though the share prices—and therefore the cover—fell below the 1.5 to 1.75 times threshold. Instead, fund houses got into an agreement with Essel group and gave the latter leeway till September 30, 2019 to pay up all its dues.
“The cover of four times, as mandated by Sebi now, is almost unprecedented,” says Kaustubh Belapurkar, director, fund research, Morningstar India, a US-headquartered MF tracking and research firm.
Two other norms, Belapurkar adds, is what tightens mutual funds’ lending against pledged shares and makes it more secure and ensures things don’t go out of hand like they did in the Essel Group case.
First, the definition of ‘encumbrance’ (a restriction on sale of shares) has been tightened. It now includes pledge, lien, negative lien, non-disposal undertaking and other such covenants. This means additional reporting and more transparency in the number of shares that are actually pledged, no matter by what name they are called.
“Second, Sebi has defined how many shares can be pledged. If the combined promoters’ shares pledged cross 20 per cent of the total share capital in the company or 50 per cent of their shareholding in the company, then promoters will be required to disclose the reasons. This, coupled with a cover of four times that funds will now mandatorily have to maintain as cover, will ensure that things do not go out of hand”, says Belapurkar.
Further, all schemes will have to limit such lending (backed by promoter’s shares) to 10 per cent of the scheme’s corpus. And exposures to a single group by way of such instruments must also be limited to five per cent of the scheme’s corpus.
Inter-scheme transfers to become stricterSebi also said that it will soon issue a circular to tighten inter-scheme transfers. Sebi observed that some fund houses used to misuse inter-scheme transfer to artificially prop up their NAVs. Here’s how it used to happen. If, say, a debt fund anticipates a higher inflow in one of its debt schemes in a day or two. But, say, its NAV is lower than what the fund house would have liked; a lower NAV shows a lower return. To prop up its underlying securities’ value—that would prop up its NAV—the debt fund would sell a portion of this security at a lower yield (and higher price; debt security prices and yields move in opposite direction) to another fund house. Based on this (higher) valuation, it then values the remaining quantum of the same security in its books and shows a higher NAV. This, Sebi said, would stop.Not sure which mutual funds to buy? Download moneycontrol transact app to get personalised investment recommendations.