Debt mutual funds are considered a popular investment option for investors who are risk averse. However, some funds’ inability to repay timely interest and principal has made a less favourable option for some investors. To ensure more liquidity and a safer investment arena, the Securities and Exchange Board of India (SEBI) introduced new rules in 2020. Though some funds welcomed this move, others are sceptical of losing their broad investor base.
Read further to know more about SEBI’s updated rules and their impact on debt mutual funds.
SEBI’s updated rules on the risk in debt funds
SEBI acknowledged that there was a liquidity crisis in debt mutual funds due to stress redemption caused by the Covid-19 outbreak. It reviewed the risk management framework and incorporated new rules. These rules were welcomed by the market as recent mutual fund news.
Here are the reformed rules issued by SEBI:
The sectoral cap is the maximum value that a debt fund can invest in one sector. SEBI has reduced the sectoral cap from 25% to 20%. As the excess 5% will be invested in other sectors, there will be more diversification. This will reduce the concentration risk.
20% liquid holdings
Debt funds have to invest at least 20% of their total assets under management (AUM) in liquid assets like government securities, treasury bills, cash, etc. This rule was already applicable for liquid funds; however, SEBI has extended it to debt mutual funds in the mutual fund investment space as well. This step could prove to be a masterstroke for countering liquidity risk.
Housing finance companies
The maximum exposure to HFCs has been reduced to 10% from the earlier 15%. The remaining 5% will be invested in affordable housing schemes by debt funds. Affordable housing schemes are not only less risky, but this measure will also increase funding in the sector.
Mark to market investments
Debt and money market instruments owned by a debt mutual fund have to be valued on the mark to market basis. The fund price will reflect the actual market value of the assets. This step can ensure a more transparent valuation of the mutual fund.
The market prices keep changing based on the demand and supply forces. In the mutual fund portfolio, some debt instruments are priced higher and some are priced lower. When the redemption pressure is heavy, buyers become risk averse. This makes it difficult to redeem lower-priced debt securities. SEBI has established an entity to buy these illiquid securities from these debt funds. This is expected to popularise investment in corporate bonds with ratings below AAA.
Corporate bonds repurchase
To enhance the liquidity of debt funds, SEBI has introduced a repurchase option in corporate bonds. Debt funds can now borrow money from financial institutions against the security of corporate bonds. This will help finance stress redemptions.
Debt funds had to liquidate high-priced securities during stress redemptions. Thus, investors who left the scheme in distress used to gain over those who chose to stay. So, swing pricing, also called the anti-dilution levy, has been introduced by SEBI. Those who make large redemptions in a crisis will attract a dilution charge to save the interest of other investors.
These measures are surely expected to reduce investor concerns and build interest in debt funds. They aim to reduce liquidity risk by diversifying the investment portfolio and taking additional security measures.