Credit rating agencies appear to be in the business of supplying what could be called scapegoat services, while mutual funds think that as long as they have a scapegoat on standby, the job of bond fund management is done.
Over the past few months, a particular type of mutual fund is in turmoil, with investors developing a strong fear of potential losses where they expect none. These are liquid funds, which are useful for one narrow purpose only, which is to keep money for very short periods of time with a very high degree of safety. Essentially, liquid funds are substitutes for keeping money in the bank but have slightly higher returns. This substitution is generally too much trouble for those of us who keep a few thousand to a few lakh of rupees in the bank, but matter a lot to larger businesses.
Investors expect - and have been led to expect - that their will be no negative surprises in these funds and each day's NAV will be more or less as predicted by prevailing interest rates. The problem is that in the recent past, there have been some cases where debt issued by a particular company has suddenly turned toxic, with IL&FS being the latest and biggest case. Invariably, there were liquid funds that lost value and investors panicked. There are probably regulatory changes being considered to improve the structure of liquid funds and that's one part of it.
A different, and fundamental problem is the one I referred to in the beginning, which is the interaction between credit rating and fund management. Before reading further, you should watch this excerpt from the movie The Big Short where one of the investment manager teams in the movie are meeting a Standard & Poor official. This short excerpt will refresh your memory about how credit rating actually works.
For fund managers, credit ratings play a central role as a qualifier of investment-worthy debt. Add to this the fact that investors in liquid funds expect a zero rate of any investment blowing up. These two facts combine to create an impossible situation. To understand why, read this thought experiment that Nassim Nicholas Taleb conducts in his book Skin in the Game:
First case, one hundred persons go to a Casino to gamble a certain set amount. Some may lose, some may win, and we can infer at the end of the day what the "edge" is, that is, calculate the returns simply by counting the money left with the people who return..Now assume that gambler number 28 goes bust. Will gambler number 29 be affected? No. You can safely calculate, from your sample, that about 1% of the gamblers will go bust. And if you keep playing and playing, you will be expected have about the same ratio, 1% of gamblers go bust over that time window. Now compare to the second case in the thought experiment. One person goes to the Casino a hundred days in a row, starting with a set amount. On day 28 he is bust. Will there be day 29? No. No matter how good he is, you can safely calculate that he has a 100% probability of eventually going bust.
This credit rating activity, even if (a big if) it is conducted sincerely and competently, cannot but produce an occasional blow-up. It's based on averages and trends and as Taleb says elsewhere, "Do not cross a river that is on average four feet deep."
This brings us to fund management's role. Finally, it's AMCs and their fund managers who are responsible to the investors. Whatever happens, the buck stops with them. Instead of ending with following SEBI's rules and credit ratings, fund management has to start from there. Their responsibility towards their investors is to deal with whatever the real world throws up - that's what they are paid for. If the credit rating agencies are less than perfect (to put it politely), then that's part of that real world and funds must deal with it.