Inter AMC Scheme Transfer
In the last 48 hours, a lot of buzz is there on how credit risk funds of some AMCs have transferred some of the lower rated papers to meet redemptions. After the fallout of six Franklin Schemes, investors are in panic and I just want to bring the negativity and panic down and see the things from a different angle.
Before we go further, it’s important to understand interest rate risk, credit risk and liquidity risk in brief.
Interest Rate Risk:
As we all know, there is an inverse correlation between price of the bond and rate of interest. This risk can be avoided by investing in schemes following roll down maturities or target maturity ETFs for hold till maturity investors.
Credit risk is the potential that a borrower (issuer) or counter party may fail to meet its obligations in accordance with pre-agreed terms. In case the issuer defaults on coupon or principal or both, investors can potentially lose their capital entirely or partially.
In an open-ended debt fund, AMC is bound to honour redemptions within 10 working days and standard business practices are to honour redemption at T+1 day, provided the investor has submitted a valid redemption request before cut-of time. In case the redemption requests (in rupee terms) received by the fund house for a scheme is greater than the liquid marketable assets in the fund, the scheme has the option to borrow up to 20% of the net AUM. What if the redemption request is even more than that? This is exactly what happened in six of the Franklin Schemes which forced the AMC to take the tough decision to windup the six schemes which were primarily on credit strategy. This is known as liquidity risk.
What we are witnessing right now is a Classic example of liquidity risk in anticipation of credit risk that going forward these companies may not be able to raise credit and can default. In last 48 hours, I have read article/blog/tweets on AMC doing Inter-scheme (from credit risk to hybrid schemes) transfers of low rated papers (I have a lot of respect for these writers). I also want to make a point in the ongoing debate. First just look at the net outflows from credit risk schemes
I agree with the following:
1) Fund Managers/AMC should stay conservative with their allocation in debt portion of hybrid schemes. This is what the adviser/distributor/DIY unitholder assumed in their portfolio construction.
2) Debt is for safety and equities are for probable Alpha. (although I am a big fan of passive strategies), but we get the point that debt portion is not for adventures.
Let’s now see the other side:
If AMC do not trade inter schemes what other alternatives did the AMC had to keep honouring the redemptions in credit risk funds:
The regulation allows schemes to borrow funds up to 20% of the AUM to meet redemption requirements. In this environment, when the month end portfolio will be out with negative cash …. BOOM, more and more redemptions will follow. Franklin did try this in six of the schemes, in fact AMC approached SEBI for an increase in
borrowing limits for certain schemes and SEBI allowed borrowing limits up to 30% for a couple of schemes and 40% of the AUM in one scheme. We all know the outcome of these schemes.
2. Restricting/Suspending redemptions:
As per the regulations a maximum suspension period of 10 working days (in 90 days) and the requirement to honour redemptions up to ₹ 2 lakh per day per investor makes this approach unviable. If the AMC takes this approach, as soon as 10 days are over, a long cue of redemption application will be waiting outside the RTA office and even the sleeping distributors/investors will get active.
3. Elongate the redemption payment :
Standard redemption pay-outs in debt funds is on T+1 basis from the date of receipt of redemption application, although regulations allow for a maximum of 10 working days for this purpose, this measure may be suitable for sailing through a short term liquidity issue but is not appropriate to address the holocaust redemption pressure the credit risk category is going through. Out come will be the same, as soon as the news get spread that AMC is taking more time than required, redemption application will have a never-ending chain reaction.
4. Distress sale:
Sell papers at distress valuations to honour the redemption, it would have a domino effect on other categories of debt funds, issuers and overall debt market.
5. Closure of Schemes:
Close the schemes which are witnessing high redemptions (same as Franklin AMC did): financial markets work on trust and closing the schemes at such scale for a country like India Mutual fund penetration is much lower than the world average. AUM to GDP ratio is only 11% in India & world average is 55%. Below is the pic from Computer Age Management Services Limited’s Draft Red Herring Prospectus. Here the debate is not about whether AMC should build concentrated illiquid positions in credit risk schemes (and other categories as well), I am completely against this concentration of illiquid issuers/group in any category of debt scheme. Also, the open-ended structure for credit schemes is something worth giving a thought.
Asset Management Companies also do not want to face the redemption heat and anger of unit holders in other schemes (equity/debt/hybrid) due to closer of one scheme. Look for instance*, Franklin India Equity Fund lost 9.74% of its AUM in multi cap category, second to only Nippon India Multi Cap Fund which lost 10.29%. In the corporate bond category (fund with AUM > 500 Crore), Franklin (40.21%) is again the first runner up in losing AUM. Story is even worse in banking & PSU debt category, Franklin AMC lost more than 31% despite significant positive inflows in the category.
*data analysed from 23rd Apr ’20 to 18th May ’20.
6. Spreading the lower rated exposure in other schemes:
by spreading the low rated exposure from credit risk schemes to hybrid schemes Asset Management Companies at this point are trying to sail through this redemption crises, this is the only viable alternative which gives AMCs (and the issuers in their portfolio) enough time to recover(pay) money from the issuers (lender). I acknowledge there is a conflict between unitholders of credit risk schemes and unitholders of hybrid schemes where the risk has been transferred.
But as the Asset Management Companies are well within their power and till the time the transfers pricing is at fair value and the transferee schemes have the mandate to invest in lower rated papers nothing much be said against the Asset Management Companies.
As always, every crisis teaches a lesson and warrants some changes.
What regulator can do?
Regulator in the recategorization 2.0 can define credit profile of equity/debt/hybrid categories. As of now only two debt categories are defined based on credit profile, corporate bond and credit risk fund, all other categories are defined based on duration with total leeway for fund managers to take call on credit. Regulator can also prescribe/revise guidelines for inter scheme transfer specially in scenarios like these for lower rated papers. Industry must also ponder on close-ended/interval funds for credit risk category.
What advisers/mutual fund distributors can do?
Smart advisers were already scanning debt portion of arbitrage funds/balanced funds/balanced advantage funds (I am not mentioning MIP, Equity Savings, etc, as those were never on recommendation list of smart advisers). Rest of the advisers and mutual funds distributors can also follow the footprints of smart advisers. Credit Risk can only be tactical portion in the portfolio and that too for clients having higher risk appetite, please do not recommend credit risk funds just for the sake of higher commissions.
What Asset Management Companies can do?
Asset Management Companies should come with low cost target maturity funds like Bharat Bond with exposure in only government securities. AMCs should adopt more and more open-ended roll down strategies with as less credit risk as possible. Nippon India Mutual Fund is converting their dynamic bond fund to a 10 year roll down maturity strategy. Apart from this there should be a firewall between fund management team and risk management department. Concentration for single issuer, single group, single sector, single investor, single distributor should be managed in schemes having credit strategies.
What investors can do?
Investors must get themselves engaged with a competent financial planner; if investors wishes to do it themselves, please diversify in different asset class like domestic equities through mutual funds, fixed income through schemes like EPF/VPF, PPF, Sukanya Samriddhi Yojana, Senior Citizen Savings Scheme, debt funds, gold and global equities.
Let’s hope normalcy returns soon!!!
This article has been written by an aspiring fee only financial planner who intends to start affordable fee only advisory after getting the licence from SEBI. Writer can be reached on twitter @stepbystep888 (Nishant Batra)