In its board meeting today, Securities and Exchange Board of India (SEBI) accepted the new valuation norms for debt mutual funds proposed by Mutual Fund Advisory Committee. Here are some of the major changes on the risk management framework of liquid funds, investment norms and valuation of money market and debt securities for fund companies.
- Liquid funds will have to hold at least 20% in liquid assets such as cash, government securities, treasury bills and repo on government securities.
- The cap on sectoral limit of 25% has been reduced to 20%. The additional exposure of 15% to housing finance companies will have to be restructured to 10% and 5% exposure in securitized debt based on retail housing loan and affordable housing loan portfolios.
- The valuation of debt and money market instruments will now be entirely on mark-to-market basis. Valuation based on amortization has been done away with.
- Liquid and overnight funds will not be permitted to invest in short term deposits, debt and money market instruments having structured obligations or credit enhancements.
- A graded exit load will be levied on investors of liquid funds who exit the fund up to seven days.
- Mutual funds will be allowed to invest in only listed Non-convertible debentures (NCDs) and the same would be implemented in a phased manner. All fresh investments in commercial papers will have to be made only in listed commercial papers. SEBI will issue guidelines on this soon.
- All fresh investments in equity shares by mutual funds will only be in listed or to be listed shares.
- There will be a cap on instruments with credit enhancements of 10% at scheme level and 5% at a group level.
- Fund houses will have to keep adequate security cover of at least four times for investing in debt securities having credit enhancements backed by equities directly or indirectly.
Further, the circular said that in order to bring uniformity and consistency in valuation, various proposals on the waterfall approach for valuation of non-traded money market and debt securities by mutual funds were approved, along with acknowledging that valuation agencies may need a certain degree of flexibility in order to ensure fair pricing of securities.
SEBI said that fund companies are responsible for ensuring fairness of valuation and they can deviate from the valuation guidelines, subject to appropriate documentation and disclosure. In order to increase the robustness of valuation and address possible misuse, various proposals related to valuation of Inter-scheme Transfers (ISTs), disallowing the use of own trades for valuation etc., were also approved.
Fund houses will be given adequate time to transition to the new norms and suitable grandfathering will be provided wherever applicable.
Disclosure on Encumbrance
Promoters of companies will be required to disclose detailed reasons for encumbrance whenever the combined encumbrance by the promoters and persons acting in concert (PACs) crosses 20% of the total share capital in the company or 50% of their shareholding in the company. The stock exchanges will maintain the details of such encumbrance along with purpose of encumbrance, on their websites.
Kaustubh Belapurkar, Director – Manager Research, Morningstar Investment Adviser India, shares his perspective.
Liquid fund norms
The regulator is looking to reduce liquidity risk in liquid funds by asking fund houses to invest at least 20% of the portfolio in cash and equivalents and also introduce a graded exit load up to 7 days, which will reduce lumpy inflows and outflows from liquid funds and also lessen their impact. Institutional investors will look to move into overnight funds for investments less than seven days. Increased cash holdings will result in lowering of overall portfolio yields.
As of May end, liquid funds on an average are holding 10% in liquid assets, rest is predominantly in CPs and CDs. A rough calculation shows that liquid funds may not be able to refinance Rs 25,000-35,000 crores worth of CPs due to this measure. This will further add to the ongoing liquidity stress in the NBFC/HFC sector.
SEBI is looking to reduce sector concentration risk by reducing sector caps. This will impact liquid fund investments in certain sectors like financials and they will need to reallocate to other sectors which could impact portfolio yields.
By doing away with amortization all together, liquid fund returns will be more volatile, while the above measures will bring down overall returns. But this will reduce the impact of liquid funds being prone to huge inflows and outflows at Net Asset Value (NAVs) which are not always reflective true portfolio values.
Investments in listed NCDs and shares
Funds in the past have invested in unlisted bonds. While we don’t know the exact quantum of exposure, these funds will need to bring down their exposure over a period of time. Listing of bonds has several guidelines, including the need to necessarily have a credit rating (there have been several instances of unrated issuances in mutual fund portfolios), increased disclosure and compliance.
Cap on instruments with credit enhancements
Mutual Funds have invested in bonds issues by entities with not so strong financials, basis the backing of a promoter entity, promoter guarantee, share collateral and other such credit enhancements. Such instruments potentially offer a higher yield. Given the new norms of limiting such instrument to 10% of portfolio and 5% at an issuer level, this move will improve the overall credit quality of portfolios. At the same time, it will also result in lowering of portfolio yields.
Cap on sectoral limit in Housing Finance Companies
There are five liquid funds, whose exposure to NBFC sector is greater than 20%, excess exposure is roughly around Rs 100 crs. There are ten funds with exposure in excess of 10% in HFC sector, excess exposure is roughly around Rs 1,100 crore.
Disclosure on Encumbrance
Given the experience with the Zee loan against share transaction, there were two important learnings : 1) The level of collateral was inadequate and 2) Given the quantum of promoter pledged shares, it would have resulted in a sharp drop in share price if all lenders were to invoke the pledge. Thus, the collateral only remained paper collateral. Several share pledges were informal and not reported under the promoter pledged shares, thus not giving a true picture of total promoter pledge. SEBI has put in place a stringent collateral cover of 4x to ensure there is adequate collateral when required. Additionally, it has bought all forms of pledges formal or otherwise to be reported under promoter pledged shares and also put in place a cap of 20% of total capital or 50% of promoter shareholding, which ensures the quantum of pledged shares are limited and pledges with adequate cover can be invoked as required.
