Eroding trust: Are mutual funds really market-linked products?

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The one big difference between a mutual fund and other conventional investment products is their so-called market-linked nature. We take this for granted when it comes to equity mutual funds but must be reminded with respect to debt mutual funds. With the ongoing FMP crisis, it appears as if the AMCs need to be reminded of this! The way they have handled Essel Group bond defaults in their fixed maturity plans (FMPs) and open-ended debt funds leave us with a lot of questions and little trust.

A debt mutual fund NAV increases or more accurately changes on a daily basis due to two factors: (1) the interest rate of the bonds – this annual interest shows up as a tiny positive movement; (2) the price of the underlying bonds in the portfolio. This bond price depends on interest rate movements and the credit quality of the bond. With regard to the FMP crisis, we are more concerned with the credit quality or the trustworthiness of the borrower. If you need to know more about interest rate risk, you can refer to this article: Understanding Interest Rate Risk in Debt Mutual Funds

I have written a similar article on credit quality risk too: Understanding Credit Rating Risk in Debt Mutual Funds. Readers who wish to know about debt funds from the basics can download this free e-book: A Beginner’s Guide To Investing in Debt Mutual Funds. If the bond held by a mutual fund does not generate interest and the borrower does not repay the money invested, it is classified as a default. The market value of such a bond is essentially zero as it becomes “junk” (no one would buy). So if the fund holds 10% of such bonds, the NAV will drop by 10% overnight. This is, (theoretically) the market-linked nature of a debt mutual fund.

Eroding trust: Are mutual funds really market-linked products?

How did the mutual fund FMPs get into trouble?

For the purpose of this post, let me explain the FMP crisis with a simple example (there is a video version linked below). Let us consider three parties: You, the reader is the investor who gives ABC, the fund manager/AMC money to manage in a debt mutual fund. ABC lends the money to several borrowers resulting in bonds (a promise of interest payment and return of principal). The third party here is one of the borrowers X.

ABC has invested your money in bonds issued by X via a fixed maturity plan (FMP). X offers as collateral shares of company Y. This means that if something goes wrong with the bond, ABC can sell the Y shares and make good the loss. Being a closed-ended fund, the FMP matures say, in April/May 2019.

It all began in January 2019!

In Jan 2019, the Y shares collapse and both companies X and Y are in trouble. So they call a meeting with lenders (that is fund houses like ANBC and other players) and plead with them (1) not to sell collateral shares and not to declare bonds of X as “default”. So ABC agrees and gives them time until Sep 2019 when they know full well that the FMPs mature in April/May.

  • ABC here refers to AMCs like HDFC, Kotak, ABSL, ICICI, Franklin, UTI, Reliance, SBI.
  • X here refers to ESSEL group companies  Konti Infopower and  Edisons Utility Works
  • Y here refers to shares of Zee Entertainment.

Notice what has happened here. The AMCs have agreed to manipulate the value of the junk bonds in the debt fund portfolios. They have agreed to not call a bond that has dishonoured terms as “default” and then make the usual song and dance about how “it was done in the interest of the unitholder”

Arbitrary Valuation at an arbitrary time?

The whole idea of a market-linked product and the whole point of marking bonds daily to market value is to ensure uniform valuation. If AMCs decide to not call a junk bond as one, refuse to mark down the NAV appropriately it is an arbitrary act that sets terrible precedence. Now they claim they will value the bond (of rolled over FMPs or those yet to mature) as per AMFI guidelines. Valuing a bond months after it became junk is atrocious and unacceptable just because the AMCs “believe that ZEE is a sound company” What is the difference then between this a real estate transaction on the street?

How is possible for an AMC to give time until September when the FMP is maturing in April (this was decided in Jan). Dear SEBI your rules are not tight enough. True protection for the unitholder is when AMCs do not act arbitrarily and/or if the rules do not permit them. The FMP crisis is a clear example that mutual funds are market linked product as per the whims and fancies of the AMCs.

My trust in them is fast eroding. SEBI, like other regulators, has almost always been reactive – make rules after the bad news – and not proactive. So both parties should not expect or do not deserve investor trust to be proactive.

Video Version

References

  1. FMP crisis: HDFC AMC says giving more time to Essel Group in best interest of investors
  2. HDFC AMC moves to deal with FMPs exposed to Essel Group
  3. Mutual funds have Rs 5,710 crore exposure to Essel Group
  4. Essel Group says have arrived at understanding with lenders
  5. Essel group troubles have HDFC, Kotak Mutual Fund seeking roll-overs
  6. Zee horror show: MF investors in 6 Kotak debt plans get a scare

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About the Author M Pattabiraman author of freefincal.comM. Pattabiraman(PhD) is the author and owner of freefincal.com.  He is an associate professor at the Indian Institute of Technology, Madras since Aug 2006. Pattu” as he is popularly known, has co-authored two print-books, You can be rich too with goal based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management.  He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. Pattu publishes unbiased, promotion-free research, analysis and holistic money management advice. Freefincal serves more than one million readers a year (2.5 million page views) with numbers based analysis on topical issues and has more than a 100 free calculators on different aspects of insurance and investment analysis. He conducts free money management sessions for corporates  and associations(see details below). Previous engagements include World Bank, RBI, BHEL, Asian Paints, TamilNadu Investors Association etc. Contact information: freefincal {at} Gmail {dot} com (sponsored posts or paid collaborations will not be entertained)
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8 Comments

  1. What should my action on this as an investor?

    If I have those bonds in my portfolio, then it makes sense to sell them now. Rather than waiting till September 19th, when the bonds could be declared junk and the corresponding portfolio becomes zero.

  2. Thanks for a thought provocating article. Investment is Debt MF is becoming as risky as Equity MF. MAy be more risky. In this circumstances, balanced funds is emerging abetter choice if the Holder can consider 6 month period for redemptions and not monthly. Its time that users shall not depend on MONTHLY basis income but a larger spread . He then has to put that income in more safe place like FD and then use for 6 months

  3. I have followed your articles and created a debt portfolio after taking into account some risk and took the chance with multiple AMCs.

    I’m surprised to see your choice of words Professor, erosion of trust? Haven’t you thought about a scenario like this in the past considering the fact that you have written tens of articles on debt funds explaining all the associated risks and measures to handle them?

    If the teacher is doubtful, what should the students do?

    1. “Haven’t you thought about a scenario like this in the past” No. What am I? An oracle to predict everything that AMCs can do? Credit risk will kick only when there is a devaluation. If they refuse to devalue junk bonds, I do not know what I or any one else can do.

      1. I meant no offense Professor.

        I asked the question because many times you think and warn of many possibilities as your articles are driven by logic and reason, I thought you must have have thought about a scenario like this too. If this is unexpected and new to you too, I understand.

        Thank you.

  4. Erosion of Trust:
    FMPs had a great track record of giving returns on the maturity date. Investors could rely on it for their cash flows (after 3 years). When we say about risk in debt mutual funds: then add one more line: “There is no guarantee that the maturity amount will be credited on the due date. But if we (AMC) feel that it is in the best interest of the unit holders to roll over, we will, considering the interest rate yields from which investors can benefit from”.

    Ideally, the money should be invested for duration less than the duration of the FMP, or simply saying the securities should mature before the maturity of the FMP.

    As said by Mr. Pattu, agreement is made in Jan to not mark the security as junk till Sep and the FMP matures in April. The AMC should display the real nature: the payment is due in April, the AMC is not able to realise the collateral, then why not mark it as a default? This is erosion of trust and SEBI should step in. SEBI is not stepping in as it may see better value for the investors without intervening. It may intervene after the whole amount recovers.

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