SEBI Mulls ‘Backstop Facility’ To Ease Stress For Debt Mutual Funds
India's market regulator is considering setting up a "backstop facility" to help purchase relatively illiquid investment-grade corporate bonds from mutual funds to ease stress in debt schemes.
"The backstop facility would be an entity, which can trade in relatively illiquid investment-grade corporate bonds and be readily available in times of stress to buy such bonds from market participants in the secondary market,” said Ajay Tyagi, chairman of the Securities and Exchange Board of India. "Of course, a broad general guiding principle for any such entity to be set up, the market participants should have skin in the game and the moral hazard problem ought to be satisfactorily addressed."
Earlier this year, mutual funds witnessed significant redemption pressure in several debt-oriented schemes, forcing them to sell the more liquid securities. Franklin Temple Mutual Fund wound up six of its debt schemes citing lack of liquidity. This ended up making portfolios even more illiquid, Tyagi said, speaking at the annual general meeting of the Association of Mutual Funds in India.
A committee with representatives from the mutual fund industry has already met to discuss setting up such an entity, which would function somewhat like a primary dealer, a senior executive at an asset management company told BloombergQuint on the condition of anonymity as the matter is still under deliberation. The person explained how it would work.
- Mutual funds would have to invest capital to set up such an entity.
- The entity would then be able to buy illiquid assets from mutual funds in exchange for government bonds.
- The size of the entity and its available pool of funds would have to be large to deal with an event like the Franklin Templeton issue.
- Therefore, it would require significant investment.
Other Measures In The Works
To deal with what it sees as lacunae in the functioning of debt mutual fund schemes, SEBI proposes to set up an expert committee to frame a stress-testing methodology for open-ended schemes in the category, according to Tyagi. While the policy for such a stress-test is being formulated, he said SEBI will soon stipulate a minimum holding of liquid assets by all debt-oriented schemes.
Tyagi also cited requests from the mutual fund industry to allow inclusion of government securities in schemes like credit risk funds, the segment facing significant redemption pressure.
Apart from the backstop facility and the stress test, SEBI has also asked the expert committee to examine liquidity risk management tools such as swing pricing or anti-dilution levy for passing on transaction costs to investors. This would entail an extra charge to investors exiting a fund en masse so that the interest of investors who stay is protected.
Boosting Repo For Corporate Bonds
Tyagi lamented that a repo market for corporate bonds had not taken off in India. A liquid repo market, which uses corporate bonds as collateral, would not only be beneficial to mutual funds holding large quantities of these instruments, but also to issuers of corporate bonds, he said.
“As per the latest European repo market survey of International Capital Market Association, in December 2019, corporate bonds as a collateral had a 17.3% share in the 8.3-trillion euro outstanding repo contracts in the books of 58 participating institutions,” said Tyagi.
To boost liquidity in the corporate bond market, he said SEBI is deliberating having a limited-purpose central clearing corporation for guaranteed settlement of tri-party repo trades in all investment-grade corporate bonds, including those rated below AAA, to boost repo trading in corporate bonds.
A Warning To Mutual Funds
In the closing comments of his speech at the AMFI AGM, Tyagi warned, “Debt mutual funds must remember at all times that there is a difference between investing and lending. Mutual funds are not banks and shouldn’t attempt to behave like one.”
Unlike banks, Tyagi said, there are neither capital adequacy requirements for mutual funds, nor do they have the comfort provided by the RBI as the lender of the last resort.