Redemption Woes For Debt Mutual Funds May Worsen, Says India Ratings

Liquidity issues in underlying assets and significant redemption pressures pose risks to debt mutual funds by way of increasing concentration over entities and sectors since the Covid-19 led lockdown was imposed.

“The redemptions are largely a consequence of the weak balance sheet liquidity of corporates, which got aggravated during the lockdown. The contributions from corporates in liquid funds and credit funds have dried up,” India Ratings & Research Pvt. Ltd. said in a report. “The challenging secondary market operating environment, coupled with bouts of redemption pressure could sharply deteriorate the portfolio quality, and that these challenges could be aggravated amid further deterioration in macro conditions and any idiosyncratic credit event.”

And that caused the assets under management of certain debt funds to fall.

“All the rated schemes showed a drop in AUM in March, which is a common trend among debt mutual funds because of fiscal end,” it said. “The change in AUM from January to April, however, shows that there have been net outflows from most funds and AUM is yet to stabilise amid the Covid-19 impact.”

Debt mutual funds, often considered as a safe bet, has witnessed a year-and-a-half of turmoil, starting with defaults at IL&FS Group in 2018 and followed by troubles at Essel Group, Cox & Kings (India) Ltd. and Anil Ambani's Reliance Group. Recently, it’s the credit risk funds that invest in high-risk, lower-rated paper in search of returns. Franklin Templeton Mutual Fund wound down six schemes as it faced redemption pressure.

The selling of top quality investments to honour the sustained redemption pressure amid weak liquidity conditions in the secondary market may adversely affect the credit quality and liquidity of the retained portfolio, the ratings agency, which has ‘outstanding’ rating on mutual fund schemes across categories, said.

While credit quality and duration of underlying investments of a scheme primarily drive the rating, India Ratings also considers liquidity, diversification of portfolio by sectors and entities, as well as maturity profile of underlying investments for qualitative rating adjustments.

The ratings agency is currently reviewing the portfolio in terms of credit quality of underlying investments and diversification to manage concentration risks and may take rating actions on mutual fund schemes that are holding securities in high concentration on a sustained basis, according to the report.

India Ratings also said frequent refinancing poses systemic challenges and that having concentrated investors could be risky in the near term.

“The lockdown has adversely impacted corporate cash flows and short-term investments and corporates will require a considerable amount of working capital to kick start production and other activities,” it said. “In such a scenario, there could be a rush to liquidate existing investments in liquid mutual funds, leading to a further rise in redemption and concurrent challenges.”

Silver Lining

India Ratings said regulators have take various steps to alleviate the liquidity risk in the system and money market, including encouraging bank credit lines to mutual funds have been effective to check significant worsening of the condition. And in absence of market normalcy and stability, debt mutual funds may continue to face multiple headwinds, it said.

But “the bright spot is that liquidity in the banking system has remained remarkably high, largely through open market operations and regular infusions through various kinds of repo windows, even if it is not getting converted into meaningful lending”, the ratings agency said in the report.