The saga of Indian debt funds continues. In the current episode, investors, analysts and the regulator have discovered some icebergs in the seas that these funds are sailing. Even though nothing has sunk so far, it's quite clear that changes are needed in the way that these funds are run. Even more importantly, there needs to be a fundamental change in the way funds report their investments to the regulator and to their investors.
Essentially, what has happened is that the old enemy of the investor and friend of the financial industry--financial innovation--has reared up its head in a somewhat strange fashion in Indian debt funds. When Essel/Zee group stocks crashed last month, attention quickly focused on the fact that the promoters had pledged their stock in these companies. With the stock price falling, it looked as if either the promoters would have to pay back the lenders at least partially, or the lenders would sell off the stock. That didn't happen, and as the news coverage told the story, the lenders with whom the promoters had pledged their shares gave them extra time.
That sounds awfully kind and sympathetic and understanding on the lenders' part. However, for a better understanding of the situation, you should google "yes minister nixon henchman quote" and read the relevant quote. Go ahead and do that right now, I'll wait patiently here.
OK, now that you've read the Yes Minister quote, you appreciate the situation that the lenders are in. The problem is that many of these lenders are actually debt mutual funds and therefore, the real lenders are the investors in those funds. Those investors did not sign up for this. The idea of investing in a debt mutual fund, as understood by investors, is that the underlying investments should be realisable at the price at which they are valued in the NAV of the fund. That means that these securities should have some sort of a functioning market with a modicum of demand, supply and trading volume. Some may be more liquid and some less but the price should be discoverable by some kind of a transparent and public mechanism.
Unfortunately, these promoter-pledging deals do not fit this description. On paper, the promoters (rather, corporate entities owned by the promoters) have created bonds underwritten by their stake and gotten them rated by ever-willing rating agencies. The sole purpose of this exercise is to give this loan-for-shares scheme a patina of a bond that is being purchased by a bond fund. Of course, it goes without saying that rating agencies are always game for any kind of shenanigan, but that's normal behaviour now which no one seems able and willing to fix so no point discussing it. In such deals, debt mutual funds have crossed the line into the bank business, in spirit if not in word. They're essentially keeping collateral and giving loans, with the bond structure as a fig leaf.
It would appear that the Essel/Zee case is just one which has floated up to the surface and there could possibly be a number of other such deals. The choice before the regulator is complex. In theory, such deals should not have been done and should be unwound. However, they are within the letter of the regulations and a hasty and disorderly unwinding will not benefit anyone and in fact almost certainly be harmful to investors' interests.
The larger question is what to do going forward. It is a legitimate point that when packaged as part of products which are meant for such financing, there is nothing intrinsically wrong with it. For example, if there are closed-end funds where the investor understands that such high-risk high-gain bonds will be bought, then that's fine.
However, that's a solution for this particular kind of pseudo-bond. The larger issue is one of behaviour. Everything cannot be anticipated and regulated. The only thing that can prevent such cases is the right disincentives against such behaviour from fund companies. That's a tougher problem to solve.
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