How SEBI’s Backstop Facility Can Bail Out Troubled Debt Mutual Funds
April 1, 2023 Mutual Fund
The Securities and Exchange Board of India (SEBI), during its Board meeting held on March 29, 2023, took several major decisions. One of the key reforms announced by SEBI is the creation of the Corporate Debt Market Development Fund (CDMDF). The CDMDF will be set up in the form of an Alternative Investment Fund to act as a Backstop facility for specified debt mutual funds during market dislocations.
What is a Backstop facility?
A Backstop facility is an entity that will buy out illiquid investment-grade corporate bonds from debt mutual funds in times of severe stress in the debt market. Whenever there is heavy redemption pressure, mutual funds find it challenging to sell their debt instruments, especially low-rated ones (instruments below AAA rating), due to risk aversion among buyers. Thus, debt mutual funds are compelled to sell good quality instruments, resulting in higher allocation to low-rated, illiquid instruments in the portfolio.
With a Backstop facility acting as a buyer, mutual fund houses will be able to readily sell their securities and generate enough liquidity to meet redemption requests.
Why did SEBI feel the need to introduce the Backstop facility?
The decision to introduce a Backstop facility comes in the aftermath of the Franklin Templeton debt mutual fund crisis. If you recall, Franklin Templeton Mutual Fund abruptly shut down six of its debt schemes in April 2020 amid the liquidity crisis triggered by the COVID-19 pandemic. Since the schemes had higher exposure to low credit quality papers, the fund house found it difficult to manage the heightened redemptions pressure in the backdrop of severe dislocation in the debt market.
There have been other occasions too, such as the IL&FS and the DHFL fallout, which had cascading effects on debt mutual funds. Many debt mutual fund schemes had to drastically mark down the value of their debt instruments due to rating downgrades, resulting in losses to investors.
Since then, SEBI has taken several measures to improve the liquidity and transparency in debt mutual funds to ensure that such instances do not reoccur. The Backstop facility is one such measure aimed at enhancing secondary market liquidity and instilling confidence among investors.
[Read: How SEBI is Planning to Ensure Franklin like Episode Does Not Get Repeated]
How will the Backstop facility work?
The Corporate Debt Market Development Fund will be based on a guarantee to be provided by the National Credit Guarantee Trust Company (NCGTC). The NCGTC is a government arm, which means the CDMDF will have a sovereign guarantee.
During a press conference, SEBI Chairperson Madhabi Puri Buch stated that the initial corpus of the fund will be Rs 3,000 crore to be contributed by specified debt mutual fund schemes (to be announced by SEBI) and asset management companies. The government has approved 10-time leverage (i.e., Rs 30,000 crore), which takes the total corpus of the Backstop facility to Rs 33,000 crore.
Only the specified debt mutual fund schemes will be able to sell the bonds during market dislocation in proportion to the contribution made to the fund at the mutual fund level. For instance, if a mutual fund contributes Rs 300 crore to the Rs 3,000 crore corpus, it will be able to draw a maximum of Rs 3,000 crore, if the need arises.
The Backstop fund will borrow from lenders such as the banking system, repo market, etc., against the sovereign guarantee. SBI Mutual Fund has been tasked with the responsibility of managing the fund.
It is important to note that the facility will be only available in case of a market-wide liquidity crisis and not in scenarios where there is normal market volatility or where a single fund house/scheme is facing liquidity issues. During phases of market stress, SEBI will take stock of the market situation and will take the final call on whether the fund can be used by mutual funds. The regulator has developed a model approved by the government, which will decide, based on various factors, whether sovereign support is required.
How will investors benefit from the Backstop facility?
The Backstop facility will ensure that during phases of extreme stress in the debt market, like the one witnessed during the pandemic-induced lockdown, investors do not have to worry about their debt mutual fund schemes shutting down or suffering heavy losses due to rating downgrades. Moreover, it will give investors the confidence to continue with their investments during volatile market conditions.
Word of caution
While the Backstop facility is a welcome step, some debt mutual fund schemes that invest predominantly in high-risk low-quality debt instruments may still face credit risk and liquidity risk even if the debt market as a whole has ample liquidity. Thus, investors need to be aware of the various risks involved before investing in debt mutual funds.
Given that the global economy is expected to face a slowdown in growth in the current year, instances of default may be on the rise. Thus, it is prudent to stay away from funds with high exposure to private issuers.
Invest in debt funds that have a predominant exposure to government bonds or quasi-government papers because these can offer better safety and liquidity.
To select a scheme, essentially assess your risk appetite and investment time horizon, plus factors such as:
- The portfolio characteristics of the debt schemes
- The average maturity profile
- The corpus & expense ratio of the scheme
- The rolling returns
- The risk ratios
- The interest rate cycle
- The investment processes & systems at the fund house
This article first appeared on PersonalFN here
