There's an anomaly in the basic design of open-ended fixed income funds, and it's something that will have to be fixed sooner rather than later
02-Nov-2015 •Dhirendra Kumar
Over the last few weeks, investors in fixed income mutual funds have been a worried lot. The proximate reason is the small loss suffered by investors in two of JP Morgan's funds on account of Amtek Auto defaulting on its bonds. However, even though the direct damage from that episode has been contained, it has left uncomfortable questions in the minds of such investors. The regulator SEBI too has been worried and has been questioning AMCs about their investment procedures and their reliance on the credit rating agencies.
Back in August, JP Morgan Mutual Fund limited redemptions in two of its debt funds, the JP Morgan India Treasury Fund and the JP Morgan India Short Term Income Fund. There was a sharp drop in the NAV of these two funds because one of the companies--Amtek Auto--whose bonds that they had invested in revealed financial issues that it had hitherto concealed. The rating agency which had rated the bonds withdrew its rating and as a result, the regulatory norms mandated that the fund had to write off its entire investment in the bonds. Later, the fund company 'side-parked' the problem investments and opened the rest of the fund for redemptions. As a result, one of the funds lost 3.4 per cent value and the other 1.7 per cent. In India, investors in debt funds are not used to this. They assume--on the strength of strong precedent--that debt funds don't make losses because of credit quality issues.
The general response to this episode has been that two parties are to blame. One, the fund managers are to blame for allowing a relatively high exposure to bonds from a company that was known to be in some trouble. And two, the credit rating agency is to blame for not putting the company on watch, and then suddenly withdrawing the rating. The regulator too is looking closely at these two factors. In fact, on credit rating agencies, SEBI Chariman said in an interview to Value Research that "the process followed by rating agencies needs to be monitored very seriously. ... this is a genuine worry, and we are working on it. We can't allow this to continue." On fund management too, the regulator is said to be looking closely at how much concentration in a company or sector is reasonable.
The above points appear broadly justified and specially on the rating agencies' conduct, some strong action is needed. However, there is a deeper anomaly in the these type of funds. What the AMCs are doing is to run open-ended funds with highly liquid one day redemption facilities backed by highly illiquid corporate bonds. If, because of some news or event, a relatively large number of investors ask for redemption in such a fund, then the AMC has nowhere to get the money from. The same news would have frozen the underlying market too. Typically, the fund manager would be forced to sell off some of the better (more liquid) holdings in the fund. That would lower the overall quality of the portfolio that is being held by remaining investors. Since fixed-income investors are professionals who would be aware of what's going on (or would surely have been made aware by rival fund companies!), there would be a run on the fund.
JP Morgan avoided this by suddenly locking the fund from redemptions and so would any other AMC have done. However, this is not a solution. Nor is it a solution to say that everyone should be more careful about their exposure and ratings. Those things should be done anyway, but they are not a real solution. These investments carry a market risks and once in a while something will go under unexpectedly.
The real solution is that funds that invest in illiquid types of assets should not be allowed to be open-ended. The liquidity offered to investors should match the liquidity available in the underlying portfolios. Without this synchronisation, we'll have more such episodes. Such funds need not have long lock-ins like Fixed Maturity Plans (FMPs). They can simply have a long cooling period for redemption requests. In developed markets, such structures are common among hedge funds that invest in illiquid assets. Investors can apply for redemption at any point, but depending on the type of underlying asset, redemption may happen 30 to 90 days later.
People in the fund industry would say that such rules would make fixed income products less attractive to investors. However, they should really compare that to what would investors do if we have a few more episodes of the type we saw in August.