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Did the Rs 50000 crore RBI fund restore the confidence of investors?
RBI’s SLF-MF of Rs 50000 crore – Background
On 27th April, RBI announced Rs 50000 crore as special liquidity facility (SLF) for mutual funds (MFs) to pacify distressed investors after Franklin Templeton closed six debt mutual funds last week. The central bank’s offering by providing assurances of adequate money to meet redemption pressures came so that the investors’ panic is abated.
The scheme has been made available from April 27, 2020, till May 11, 2020, or up to utilization of the allocated amount, whichever is earlier. RBI will review the timeline and amount, depending upon market conditions.
Mutual Funds were already facing a massive liquidity crisis considering the intensified volatility in capital markets due to the COVID-19 pandemic. The crisis, however, has taken a turn for the worse as the redemption pressures have increased upon the closure of 6 Franklin Templeton debt funds. According to RBI, at this stage, the pressure is now on high-risk debt MFs, while the larger industry remains liquid.
RBI also said in their report that under the SLF-MF, they will conduct repo operations of 90 days tenor at the fixed repo rate.
Banks will use the funds availed under the SLF-MF only for meeting the liquidity requirements of MFs. And this will be done by extending loans and undertaking the outright purchase of repos (repurchase agreement) operations.
Impact of RBI’s Rs 50000 Crore Action
1. Investors Left Holding Overvalued Bonds in a Leveraged Portfolio
The AUM (assets under management) of debt schemes in the mutual fund industry is INR 15 lakh crore, which is more than half of the total AUM of Indian fund houses. Credit Risk funds that account for 5% of the overall debt assets are the worst-affected sub-category of debt funds. Investors, albeit, are skeptical about the overall credit quality of the assets, due to which, debt schemes are most likely to see a rise in redemptions.
A mutual fund can borrow only up to 20% of its assets to suffice liquidity needs for redemption or dividend pay-out. Undoubtedly, the first ones to request redemptions will benefit from this while those who wait out will end up holding a fund full of bonds that are overvalued and cannot be sold. Assuming that fund houses like Franklin Templeton borrows 20% of AUM to meet redemption requirements, the remaining investors in the fund will be left to pay interest on that loan while sitting on a portfolio of overvalued bond assets. This essentially increased the overall risk for investors manifold as compared to what they originally signed up for while subscribing to the fund.
2. Underlying Problem Remains Unresolved
India has had one of the smallest corporate bond markets among major economies for as long as one can remember, not to mention, the lack of a well-functioning secondary debt market. This combined with its liquidity crisis has aggravated the problem. The Franklin fiasco was a combination of the above two factors and the fund managers’ taste of higher-yielding riskier corporate debt. This doesn’t help the current situation, which could have been avoided if there were a secondary debt market.
3. The bad debt crisis in the Shadow banking system is likely to deepen further
India is said to have a high bad debt ratio. Something we saw with the Yes Bank Ltd fiasco in March. As traditional lenders cut off bad loans, shadow banks gushed in, borrowing short-term funds that they lent out for longer periods. Remember the IL&FS crisis in 2018 and the panic redemptions that loitered around long after?
Earlier, the shadow banks used to rely on yield-seeking mutual funds like Franklin Templeton to get funds. But now with the Franklin Templeton crisis, it will get harder for India’s shadow banks to raise capital through this route.
After the Franklin Templeton crisis, redemption pressures from debt funds as well as equity mutual fund investors have been mounting upwardly. Unlike in equity funds, wherein, asset management companies (AMC) can sell shares at a loss, in debt funds, selling bonds/commercial papers is difficult as there are no buyers.
A mutual fund can only avail loan under SLF for 20% of its AUM, which means that if investors redeem 20% of the fund’s size, other investors will not be able to exit until liquidity restores. But the SLF-MF’s second-order consequence was that the debt fund investors panicked and began to redeem more than they should have. RBI’s move essentially incentivizes redemptions for those who go for it first and bails out participants who consciously took higher credit risk for higher yield. In other words, any financial crisis is eventually resolved by allocating and absorbing losses. Everything else is merely an arrangement that postpones the inevitable.
If you have invested in debt mutual funds, get your portfolio scanned by your trusted advisors at Kristal.AI here. We are closely monitoring the situation and took preemptive action in our client’s portfolios before the fallout.
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