Addressing liquidity issue by debt funds | Value Research Dhirendra Kumar discusses how AMCs manage liquidity issues
Ask Value Research video-icon

Addressing liquidity issue by debt funds

Dhirendra Kumar discusses how AMCs manage liquidity issues

How does a debt fund address the liquidity issue in the best possible way and why could not Franklin address it well? Also, why is SEBI so adamant about the limit of 20 per cent borrowing to handle the redemptions?
- Pradeep Kumar Gupta

Debt funds address the liquidity issue in multiple ways. One is by constructing their portfolio in a manner that they can liquefy their portfolio or sell a good part of it efficiently. But at the same time, different kinds of debt funds have different frameworks to operate in. For example, an ultra-short-term debt fund will work in a different way, so will a liquid fund. Likewise, an overnight fund naturally expires every other day, as it invests in overnight securities only.

Having some portion of the money in highly liquid securities is another way. The ability to borrow, as well as having a ready credit line, is another way to manage liquidity. Going on a higher credit rating scale is also helpful because bonds with superior credit rating may have superior liquidity as well. So, this is how AMCs prepare themselves for higher liquidity.

To answer your question regarding the Franklin case, it was the result of a few bad things happened simultaneously. For one, all Franklin's funds had credit exposure, then Covid happened. Even before Covid, the debt fund crisis owing to the IL&FS blow-up was already continuing for more than a year. Amid all this, we saw extreme risk aversion and the corporate debt market dried, as there were no buyers and only sellers. Further, Franklin was also the most inappropriately placed, as it was one of the biggest players in terms of investments in the credit market, you can say Franklin was half the market. It was almost like the underlying market of the securities invested by Franklin got frozen. So, that was an extreme situation.

Coming to the 20 per cent borrowing limits provided by SEBI, this is the prudent thing in normal conditions. If SEBI allows 100 per cent, then the fund will have a sizable borrowing and it will have no investors' money. To my understanding, even 20 per cent is high because these borrowings will have interest costs, which investors will have to bear to some extent. Further, SEBI laws prohibit mutual fund companies to charge interest cost more than the return on the fund, which means the AMC themselves will have to bear the additional costs of the borrowing to honour the redemption.

We should not forget one thing that mutual funds are a pass-through and that is the spirit which should be enforced. Unfortunately, there is a huge gap between the way debt funds are designed and the kind of dissonance or the arbitrage it creates. When you buy a debt fund, you can redeem your investment and get your money back anytime but when the fund company is investing your money, it cannot redeem or call the investment that it has made on your behalf the way you can take your money.

In my opinion, the kind of bad coincidences that happened to Franklin may happen again if a lot of investors turn up to take all their money at once. In such a situation, all the securities cannot be sold at that instant. More so at a point when the context/situation will be grim that even the underlying market will not be able to absorb that kind of investors' need for liquidity.
Having said that, we have a good amount of checks and balances and calamities happen and may happen again. But we must see how best we can mitigate the impact. Right now, I find that there is an even greater risk aversion. If you look at the returns of corporate funds, last few months have been one of the best months for them simply because they were so poorly priced that everybody was willing to sell it at any price. Their prices really went down to such levels that they have made a significant comeback.

Now, all this will create aberrations, opportunities and havoc and you must see on which side you are. Maybe for investors, the lesson to take is to diversify and keep away from the funds taking extreme positions and that is about it.

Have a different question in mind? Ask us

Other Categories