Here is the link of the article: https://www.capitalmind.in/2020/05/podcast-27-the-run-on-debt-mutual-funds-is-your-money-safe/
This podcast is on debt mutual funds where Deepak Shenoy is sharing how debt mutual funds work, where they invest further, and how to evaluate them.
He starts with discussing the size of debt mutual funds in India. He tells that more than 50% of mutual funds are debt and in terms of money almost Rs. 13 lacs crore is in debt fund (more than 50% of Rs. 25 lacs crore). Out of these 13 lacs crore, Rs. 6 lacs crore are in liquid funds (debt funds for a day to a week). On FD market, he shares that FD is almost 6 times of debt market in India. Among overall money supply in India almost 50% is in FD’s (around Rs. 73 lacs crore out of Rs. 150 lacs crore).
On being asked about why people go to debt mutual funds he said that there are no FD’s for very short term such as 7-days, 10-days or 15-days. If people require money they will have to break FD and it doesn’t yield interest so people prefer debt mutual funds. Also FD’s give you only interest whereas debt mutual funds earn interest and they reinvest this and you get benefit of compounding (tax benefits are also there). So overall you get tax benefit, liquidity benefit (you can sell before maturity), compounding benefit too in debt mutual funds.
On different category of debt funds, Deepak Shenoy shares that there are a variety of debt funds on the basis of duration (such as overnight funds for very short time, liquid funds for 3 months or less, ultra short term funds for 3-6 months, short term for less than a year and so on), on the basis of credit risk etc. Investor should invest in debt mutual funds according to his comfort like if he want to invest money for 3 months he should not invest in debt funds of longer tenure even though he can sell it before maturity.
He further shares about growth and dividend option where in dividend investor receives payments frequently at certain intervals but in growth all money is reinvested. He also tells about direct and regular plans where in regular plan there is a middleman who earns commission no selling any product (product here is mutual fund scheme) and in direct option investors directly purchases it from AMC’s website. Direct option is more beneficial because there is no commission in between.
On being asked about what kind of instruments these mutual funds park money in, he starts with the example of the bank giving loan to a company. In this the whole risks lies with bank even if company defaults in payment depositors will get their money. But in case of mutual funds parking their money with corporate risk lies with investors as if corporate defaults then investors will lose money and not mutual funds. Debt funds invest according to their category like short term funds invest in short term instruments, overnight funds invest in overnight instruments, GILT funds invest in government securities etc.
He further discuss about Additional Tier 1 bonds. In this bond, issuer pays higher interest because if issuer is facing hard times it will not pay interest or principal (and that’s the same thing written in contract). Mutual funds also own AT1 bonds but the risk completely lies with investors.
When asked about how the money is deployed when an investor invests money in mutual funds, Deepak Shenoy gives two examples – one of normal times and one of crisis times.
In normal times, investor invests money and redemption is very low. So the inflow for the AMC (investor’s money and interest paid on bonds or matured bonds) is adjusted with outflow (if any investor wants to redeem) and remaining net cash is invested.
In crisis times, the redemptions are more so whatever money new investor puts in is mainly used for redemption. In such times mutual funds are not net buyers but are net sellers because they sell their investments in order to pay to the investors who are redeeming.
On NAV, he shares that shares don’t have a problem because at whichever price it is trading people can buy it. But in debt instruments there is a liquidity problem. So the question arises how to determine their NAV’s?
Mutual fund uses some matrix to determine NAV and the matrix is somewhat like this – if fund’s total value is Rs.1000 and there are 10 units then NAV is Rs.100 (1000/10). So in good times NAV is good but in crisis time when everyone is rushing to sell the NAV’s see a drop.
There’s a big gap between the actual liquidity of the things that these debt mutual funds invest in and the liquidity that’s promised (implicitly or explicitly) to a customer. These gap in the liquidity can be exampled by with the help of an example.
For example, there is an ultra short term fund whose maturity is around 3 to 6 months wherein the instruments range from 2 to 8 months whose average fits the category requirements.
In case of a bad market, the investor needs to wait till the maturity to get the amount back.
However, there are cases where the investor may need to wait even till 5 years to get back his money because the formula described to calculate the time period isn’t efficient enough. For example, the fun invests in floating rate bonds pegged to a benchmark. Now, lets suppose the interest is reset every 6 months which qualifies the investment to come under the required duration according to the formula.
During Redemptions, there are a lot of bonds that can’t be sold which means their weights keep on increasing in your portfolio simply because of SEBI rules. SEBI should allow funds to take such bonds and put them in a separate portfolio where the returns will come only when the bonds mature.
These means that the actual liquidity that has been promise is not the same as what the investment allows.
Credit Risk funds say that you can redeem every day and invest in long term instruments.
One bit is where you have got debt which is not good debt in the first place. Promoter own companies borrow money in the promoter. The purpose of raising the money is justified and shares kept as collateral. Also, there are no intermediate interest payments. And thus, when the date of maturity arises, the promoter raises another loan to repay it. In this way, the promoter rules over these loans till the time when no one wants to by that bonds.
One thing that you should look the mutual funds are not the FD lenders to the company.
The FD money goes into loans to companies which aren’t liquid either. So it is questionable whether FD’s are actually safer or it is just un justice. However FD’s are just safer becauseabout 20% of the amount in FD is to be parked in government securities which have negligible risk and enormous liquidity.
RBI acts as a lender of the last resort to the banks and saves them by extending loans against deposits.
Also, there is a government guarantee of Rs. 5 lakhs per depositor.
RBI does not want to help the mutual funds directly. It wants the banking institutions to be the buyers for the mutual funds. RBI has provided 50000 crores to banks who have in turn agreed to buy those funds who have invested in less risky instruments and not the junk paper.The banks have been directed to buy both from the market as well as from the companies directly.
The impact of mutual funds turning into sellers can be the reason for a huge crisis. In India, the mutual funds have disagreed to roll over the debt of the companies as they are acting as sellers in the market. There are companies who will require loans for working capital requirements. They have adapted themselves to rolling over loans and fulfilling their requirements.
The companies cannot go to banks as their lending rates are pegged to the MCLR. Thus, the banks say that if the mutual funds were lending you at 6.5%, they will charge 8% from them, which is huge enough to destroy their margins and losses may erupt.
Thus, a high rate of interest charged by banks and non-availability of funds from mutual funds will result in many companies going under due to interest obligations and liquidity concerns. RBI needs to intervene to not let the liquidity dry up.