Analysis: SEBI questions MFs placating big borrowers and corporate investors in debt schemes

The Securities Exchange and Board of India (SEBI) has made public that it was discontent about the questionable practices of mutual funds which created a series of fiascoes in fixed maturity plan (FMP) debt schemes.

After its Board meeting on June 27, SEBI Chairman Ajay Tyagi categorically stated that the market watchdog does not recognise standstill agreements between promoter who borrowed capital, and the investing mutual funds. MFs are not banks, and they should be investing rather than lending, asserted the SEBI Chairman.

Among the many steps taken by SEBI for mutual funds in its board meeting, those on the valuation of debt assets was a highlight.

In a press release, the regulator said valuation of debt assets have been shifted entirely to the market traded value of securities, and will not include amortization value. Amortization is the distribution of the cost of an intangible asset over time.

Himadri Buch

Assistant Editor|Moneycontrol.com

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This was done because, as this previous piece had flagged, MFs go out of their way to appease corporate borrowers, over retail investors.

Till some time back, the debate in the MF industry was centred around preference to a few corporate investment clients over the retail ones. This was despite SEBI incentivising fund managers and distributors by making changes in expense ratio and entry/exit loads to attract retail investors.

Since the Essel Group defaulted a host of debt schemes in January 2019, MFs stood exposed.

HDFC MF dug into its IPO money to payout Rs 500 crore for Essel paper default in its schemes. This was after it received a notice from SEBI on questionable standstill agreement with the company and withholding investor funds which were due in January 2019 till September 2019.

This exposed a serious governance issue as IPO money is not for investment guarantees, but growth and development of the mutual fund.

The point to examine is that MFs seem to realise non-payment from the likes of Essel and DHFL only in the last month of the long term FMP debt scheme. One answer lies in their valuation method of the debt papers in schemes through amortization.

Since SEBI mandated circular of February 28, 2012, debt papers above 60 days are valued at weighted average traded market price. And debt papers below 60 days maturity on amortization basis is an option.

Near the maturity of FMPs i.e. less than 60 days, the debt of Essel, DHFL would be valued at amortization. This means all scrips that mature up to 60 days are to be accounted for, on an accrual basis.

In simple words, an accrual method means that the interest of the underlying security is amortised over the tenure of the scrip and the daily interest so arrived, is then added to the price of the scrip at which it is bought. The net asset value (NAV) therefore increases daily at a steady pace.

Here is the twist to the tale. In the event of a loaned corporate declaring inability to pay on the date of redemption, the entire amortization formulae used so far including the return of principal with interest crumbles. Then MFs may resort to tricks like standstill agreement to postpone investor redemption payments.

SEBI’s objections rightly express its disagreement over such gross oversight, wherein for a year or so of FMP duration, MFs played along thinking that money with interest will be returned on the redemption date.

MFs are exposed on two counts, one on in-house systems for tracking continuous creditworthiness of borrowers, and second the NAV valuation of FMPs not reflecting the actual market value of debt assets.

This has made the SEBI take the hard step and do away its amortization valuation.

Now MFs have to value all debt assets on market value, which is the actual creditworthiness value of each debt paper in debt schemes. MFs thus cannot be the guarantor of returns to debt scheme investors and what risk value debt papers carry. Its debt scheme corporate investors shall have bearing based on the market value of debt papers.