SEBI’s order on FT may push fund houses to take fewer risks on debt schemes

The Securities and Exchange Board of India’s (SEBI’s) action against Franklin Templeton Mutual Fund (FT MF) – fine of Rs 512 crore, and barring new debt fund launches for two years – has made others wary. Fund houses are now worried about their risk management practices when it comes to handling schemes with high credit risks.

The penalty was imposed on the grounds that FT MF was running its duration debt schemes like credit risk funds, which was not in the spirit of SEBI’s categorisation rules.

In its order on FT MF, SEBI also pointed that there are “multiple duration-based schemes of other mutual funds, which carry significant exposure (and in many cases over 65 percent) to AA and below-rated securities over a consistent period of time.”

Credit risks in duration schemes

Industry executives say fund houses are going to be highly cautious as such a steep penalty can take away large chunk of an AMC’s profits. And any bar on new scheme launches can hurt business growth.

“SEBI’s move is a loud and clear message for any fund houses that if there are any lapses the regulator can take stringent actions,” says the chief executive officer of a fund house, requesting anonymity.

Also read: Fundsgate: How the Karnataka High court shredded Franklin Templeton’s and SEBI’s arguments on investor consent

Apart from credit risk schemes, medium duration funds sometimes take credit risk calls.

According to data from AMFI, the assets under management (AUM) handled by credit risk funds stood at Rs 25,385 crore at the end of April 30, 2021, while the medium duration funds had a combined AUM of Rs 30,529 crore.

Data from ACE MF shows that one-third of assets of medium duration funds have investments in debt papers rated AA and below.

The categorisation rules never strictly stipulated the credit rating of the debt securities that duration schemes can invest in. Rules say a credit risk fund needs to invest at least 65 percent of its assets in AA and below-rated debt papers, but the duration schemes of FT MF had also invested 65 percent in such debt securities.

Industry executives say that SEBI’s order clearly lays down the intent of the regulations, and how it wants schemes other than credit risk funds to be managed.

Valuation of debt securities

The regulator raised concerns on the manner in which debt securities held in the schemes of FT MF were being valued.

For example, the market regulator has come down heavily against FT MF for valuing the debt securities on interest rate-reset dates and not as per their maturity dates. It said that this allowed FT MF to invest in long- maturity papers in its shorter duration schemes.

Also read: Karnataka HC raps Sebi for not being proactive in Franklin Templeton wind-up

“We have heard about instances of other fund houses also following this practice. SEBI’s action will serve as a strong deterrent to such practices,” said a debt fund manager, requesting anonymity.

Industry sources suggest this was also common practice when it came to valuing additional tier-1 or perpetual bonds of the banks.

The regulator also spoke out strongly against FT MF’s decision not to exercise the exit option on debt securities that had turned illiquid.

Also read: One year after Franklin Templeton episode: Loss of reputation, but repayments restore faith

“The regulatory move will make fund houses more sensitive to the risks in their debt schemes and clean-up their portfolios where they sense potential trouble,” the fund manager added.