Budget 2021: Will bad bank help debt mutual funds get rid of bad securities?

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© Nishant Kumar Budget 2021: Will bad bank help debt mutual funds get rid of bad securities?

Social / Tweet: #Mutualfunds say #Budget proposal to set up a body for purchasing corporate #bonds is a positive move, but clarity needed on whether the body will participate in below highest-rated debt papers, and have enough funds

Finance Minister Nirmala Sitharaman in Budget 2021 speech proposed setting up of a body that will purchase investment-grade debt securities in stressed markets, as well as in normal conditions.

Sitharaman said that such a body will help to “instill confidence amongst the participants in the corporate bond market during times of stress…”

This move comes in light of the sharp liquidity crunch that was felt in the bond markets following the Covid-19 outbreak, which forced Franklin Templeton Mutual Fund (FT MF) to close six of its debt schemes with combined investor assets of Rs 25,856 crore.

Also read: SC asks Franklin Templeton to return money to unitholders from cash-positive schemes

But will this move help mutual funds (MFs) if trading activity in bond markets were to slow down again, and withdrawal requests by investors surged, like last year?

High to low grades

Marzban Irani, chief investment officer (CIO)-debt, LIC MF, says setting up of such a body will be quite helpful, but we will have to wait and watch whether this body indulges sellers with securities spread across investment grades.

The investment grades range from BBB- to AAA+. Debt securities rated BBB- carry higher risks. The degree of risks lowers as the grade moves closer to AAA+, which is the highest credit rating. Any rating below BBB- is non-investment grade.

When there is a lack of liquidity, even below-AAA rated debt papers are difficult to offload for MFs, without taking a cut on the pricing of such securities.

Liquidity to lower-rated debt papers was hard to come by last year, despite the Reserve Bank of India (RBI) launching Rs 1 trillion targeted long-term repo operations (TLTRO) to support corporate bonds after the Covid-19 outbreak. For example, stressed non-bank finance companies (NBFC) did not receive much of this funding as banks largely used the TLTRO funds to lend to high-rated NBFCs.

Overall, NBFCs and housing finance companies had requested Rs 76,843 crore (as of September 4, 2020), but four-fifth or Rs 61,474 crore of this demand was met, Reserve Bank of India’s (RBI) trend and progress report says.

As per data from the report, which was released in December last year, 70.3 percent of the funds went to AAA-rated NBFCs, 17.7 percent to AA-rated, and just 9.9 percent to single A-rated bonds of NBFCs. NBFCs with ratings of BBB or those unrated, where stress was high, received just 2.1 percent of TLTRO funds.

Where will this fund get the money to buy illiquid securities? “It needs to be seen if this one body will have enough funds to meet liquidity needs at times of stress in the corporate bond markets. But it’s a good move,” says Dwijendra Srivastava, chief investment officer-fixed income at Sundaram Mutual Fund.

According to data from ACE MF, debt MF schemes had exposure of Rs 4.6 trillion to the corporate bond market as of December 31, 2020.

What about below-investment-grade?

As the Budget speech suggests, this body will not participate in below-investment-grade debt papers, at least initially. Fund managers hope that over time this body can be also allowed to trade in such distressed debt papers.

As per data from ACE MF, the MF industry is stuck with Rs 1,268 crore of corporate debt that is rated below BBB- or those that are unrated. In several of these investments, either the company has defaulted on payments, or the ratings have been downgraded or suspended due to questions on the company’s ability to service its debt repayments.

As it is virtually impossible for schemes to find buyers for such debt papers in the markets, debt schemes side-pocket these investments and wait till dues are recovered. The net asset values (NAVs) of such side-pocketed units are marked down and only marked up as and when the investee company makes repayments. In some cases where the company is facing litigation, the wait can be longer.

Other options

While an external agency may have its own limitations in terms of the number of investments it can make or conditions in which it can intervene, experts say debt schemes should keep enough liquid investments at all points of time to handle any crisis.

“Even as the new institution is being set up, portfolios will need to incorporate adequate liquidity to ensure they are able to handle tight liquidity conditions from time to time,” says Kumaresh Ramakrishnan, CIO-fixed income, PGIM MF.

After the FT MF’s scheme wind-up move last year, debt MFs have been cautious and keeping liquid investments that can be easily sold even in stressed market conditions.

Last year, as the Securities and Exchange Board of India (SEBI) relaxed the minimum investment rules, on request of the MF industry, even debt funds with a mandate to invest in corporate bonds, took sizeable exposure to liquid papers like government securities (G-secs).

Following the tweak in norms, such funds could invest an additional 15 percent in liquid debt securities such as G-secs and treasury bills.

While this was a temporary relaxation, all open-ended debt schemes (where investors can freely invest and withdraw funds), are now required to keep at least ten percent of their investments in liquid assets, effective from February 1, 2021.

If a scheme doesn’t have enough liquid investments, SEBI regulations also allow MFs to take loans from banks or non-bank lenders, but the borrowing should not be more than 20 percent of the scheme’s investments.

Last year, the RBI opened a Rs 50,000-crore borrowing window for MFs after FT MF episode, but MFs hardly used this two-week window (borrowing just Rs 2,430 crore). The SEBI-allowed window and schemes’ liquid investments helped MFs to tide over this tough period.

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