Although market regulator SEBI’s chairman Ajay Tyagi has publicly frowned upon standstill agreements, he has stopped short of specifying citing any exact clauses of violation. But SEBI’s September 24, 2019 circular seems to have taken the sting out of such agreements. It says that if the terms of an agreement (of a mutual fund’s investments in a debt security) change – an extension in the maturity of money-market or debt instruments – the security should be treated as being in ‘default.’ The circular itself lays down detailed and revised guidelines on how debt funds should value their underlying securities.
Nearly a year after the Infrastructure Leasing & Financial Services (IL&FS) crisis broke out and took down debt funds in the credit problems that ensued in the aftermath, these guidelines promise to make your debt funds more transparent. And, a bit safer as well. Having sharpened the boundaries within which debt funds should value their securities, SEBI has asked the Association of Mutual Funds of India (AMFI; the MF industry’s trade body) to come up with granular guidelines within 15 days. Let us look at the four most important measures that SEBI has taken to clean up your debt fund.
The waterfall approach
The return that your debt scheme makes depends on your fund manager’s skills. But as the bond markets are illiquid and transactions are usually conducted over the telephone (unlike equities where transactions get conducted only on stock exchanges), debt funds also face the challenge of how the underlying securities are valued.
SEBI’s measures aim to make your debt fund more transparent in the way your fund values its underlying instruments. In other words, SEBI has brought about standardisation to ensure that if a credit event happens, all affected funds would value their securities in a similar way. It has imposed, what it calls, a waterfall approach. In simple words, this means a step-by-step approach to get the true value of the securities.
Fund houses will continue to rely on external agencies (presently, CRISIL and ICRA provide the prices of all debt securities that bond funds have invested in, daily) to value the securities that are traded.
For non-traded securities, the valuation agencies will now step in more authoritatively than before. Up until now, there wasn’t a formal process to value such defaulting securities. Fund houses would either call other AMCs (asset management companies) or brokers to arrive at a consensus or, worse, carry out an inter-scheme transfer at a certain price and use that as a reference to value the remaining quantity of the same security.
Bringing order after chaos, SEBI has now made it mandatory for fund houses to rely only on valuation agencies to arrive at the prices of non-traded securities. These agencies would poll a few fund houses that they choose; AMFI would lay down the polling guidelines and the fund selection process. Fund houses whose names get drawn on a given day of polling must participate. Once the valuation agencies arrive at a suitable price for an untraded security, all fund houses would need to adhere to it.
Keeping fund houses on the same page
Also, to regularise the highly illiquid debt market that gets conducted largely over the telephone, SEBI had already mandated earlier this year that all debt funds must report all their trades on certain platforms. They can, however, continue to buy and sell the way they do. That way, information is legitimately shared and everyone gets to know the buy-sell prices of all securities.
Bond prices must be reported on the BSE or the NSE and money-market instruments’ prices must be reported on F-TRAC – a platform of the Clearing Corporation of India.
But a question that arises is: how to value securities that are downgraded? A few months ago, the AMFI mandated all fund houses to follow a uniform matrix that guides them on how much to mark down a below-investment-grade security, in case of a credit-rating downgrade. In addition to sharpening the definition of a below-investment-grade security, SEBI has said that this matrix will continue and fund houses will now have to uniformly mark down their downgraded securities, till the valuation agencies subsequently arrive at a fair-value, eventually. The age-old concept of non-performing asset that was present in SEBI regulations has been done away with – NPAs were irrelevant to mutual funds anyway – and the regulator has now standardised the norms of how fund houses should account for rating downgrades and defaults, and the disclosures to be made in such cases.
These are the broad contours of how securities will get valued, but we await AMFI’s detailed guidelines.
All securities to be marked to market
SEBI has mandated that all securities will be marked to market from April 1, 2020. Currently, securities with maturity of up to 30 days are amortised. In simple words, the interest accrued is simply added to the issue price; this shows the security’s price moving up in a steady line till maturity. Earlier this year, SEBI had mandated valuation agencies to issue prices for such securities as well, but fund houses are allowed to amortise such securities till maturity, provided the gap between the amortised price and reference price given by valuation agencies does not exceed plus or minus 0.025 per cent. But starting April 2020, fund houses will mark to market all their securities, irrespective of their maturities.
“This is a good move. All such reforms sound a bit alarming at first. But any kind of bottled-up risks could be harmful in future if left untreated. Therefore moving to full mark-to-market is always beneficial”, says Shriram Ramanathan, Head- Fixed Income at L&T Investment Management Ltd.
Starting April 1, 2020, liquid funds must hold at least 20 per cent of their assets in liquid instruments such as cash and government securities. To make short-tenured funds safer, SEBI has barred liquid and overnight funds from investing in short-term deposits of banks and debt securities that come with structured obligations or credit enhancements, such as ‘loan against shares’ instruments.
SEBI has also modified its mutual fund regulations on September 23, 2019 by barring mutual funds from investing in unlisted securities, such as commercial papers. Though this is now a law, the MF industry awaits the exact date of implementation. Mahendra Kumar Jajoo, Head-Fixed Income at Mirae Asset Global Investments (India) says that eventually liquid funds would become more volatile than before, but that it is no cause for concern. “Liquid funds will now not be looked at as vehicles where you can park overnight cash. Linearity of liquid fund returns would no longer be a norm and returns would become much more volatile. For overnight parking, overnight funds will become the chosen schemes,” he says.
Inter-scheme transfers
SEBI has brought some order in the way fund houses transfer securities within their schemes. Many times, when a security becomes highly illiquid, fund houses sometimes transfer them to some other scheme, usually to a closed-end one where there is no redemption pressure. Fund houses typically used to take the previous day’s closing price. “But now fund houses will have to take the prices that valuation agencies give. Many fund houses had already moved to using valuation agencies, but writing it down in the circular makes it very black and white,” adds Shriram.
Pouring cold water over stand-still agreements
In January 2019, several fund houses had given a reprieve to the Essel group by extending the loan tenure. This was widely referred to as a standstill agreement. The loans, which were supposed to have matured around the first quarter of 2019, were extended up to September 2019. With news now coming out of another standstill agreement – extended up to March 2020 – SEBI’s latest move will ensure that even though fund houses enter into such agreements on their own, they would need to mark the securities as having defaulted. In other words, the values of such securities would be completely written-off and the NAVs must fall. Previously, industry experts say, fund houses had not marked the said securities down, even though the instrument did not repay the money.
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