October 22, 2019

Will the New ‘Waterfall Approach’ by SEBI make Debt Mutual Funds Safe to invest in?

Jimmy Patel
MD & CEO, Quantum Asset Management Co. Pvt. Ltd.

Will the New ‘Waterfall Approach’ by SEBI make Debt Mutual Funds Safe to invest in?

Reviewing the scenario of heightened credit risk in the Indian debt market and its impact on investors, the capital market regulator, SEBI has been continually taking a number of measures.

In the past,the capital market regulator…

  • Issued prudential norms governing liquid funds and other debt & money market instruments
  • Prescribed graded exit load for liquid funds
  • Changed valuation norms for below-investment grade securities
  • Asked mutual fund houses to shift all their investment to listed or to-be-listed equity and debt securitiesin a phased manner
  • And even pulled up credit rating agencies for their high laxity and enhanced their disclosure norms

Marching ahead, recently SEBI further refined valuation norms for debt and money market securities vide a circular.

Among a host of things, the regulator has prescribed a ‘Waterfall Approach’ to arrive at a security level pricing.

The principles adopted under the ‘Waterfall Approach’ as prescribed by SEBI are:

  1. All traded securities shall be valued on the basis of traded yields, subject to identification of outlier trades by the valuation agencies.
  1. The Volume Weighted Average Yield (VWAY) for trades in the last one hour of trading shall be used as the basis for valuation of Government Securities (including T-bills). Valuation of all other money market and debt securities (including Government securities not traded in last one hour) shall be done on the basis of VWAY of all trades during the day.
  1. In case of any exceptional events on a day, only VWAY of trades post such event may be considered for valuation. Further, all exceptional events along-with valuation carried out on such dates shall be documented with adequate justification.
  1. All trades on stock exchanges and trades reported on trade reporting platforms till the end of the trade reporting time (excluding Inter-scheme transfers), should be considered for valuation on that day. Towards this end, the timing for disclosure of Net Asset Value (NAV) stands extended upto 11:00 p.m. for uploading the NAVs of all schemes (except Fund of Fund schemes) on the website of AMFI and respective AMCs.

Further, considering the importance of polling in the valuation process, the capital market regulator directed the Association of Mutual Funds in India (AMFI) to issue guidelines on polling by valuation agencies — who will also be appointed by AMFI.

Plus, AMFI is expected to issue guidelines on the responsibilities of mutual fund houses (or Asset Management Companies)in the polling process, as part of the aforesaid Waterfall Approach.

Valuation agencies are expected to identify the Mutual Funds who shall participate in the polling process on a particular day. Plus, AMCs (Asset Management Companies) shall have a written policy, approved by the Board of AMC and Trustees, on the governance of the polling process, and care to needs to be taken to mitigate the potential conflicts of interest in the polling process.

The AMCs are expected to ensure that participation in the polling process is not misused to inappropriately influence the valuation of securities. The AMCs are expected to maintain an audit trail for all polls submitted to valuation agencies.

Plus, senior officials at the AMCwill be held responsible for polling the process and personally liable, in case the polling process is misused.

The aforesaid waterfall approach shall form part of the valuation policy of individual AMCs. AMFI is expected to ensure that the said waterfall approach is also available on the website of AMCs and the valuation agencies plus it is documented well, says the SEBI circularexplicitly.

Notwithstanding the above, SEBI has also updated the definition of traded and non-traded money market and debt securities.

Further, since the valuation methodology for thinly traded debt securities is same as non-traded debt securities, SEBI has done away with a separate definition of thinly traded debt securities.

Also, the circular states that the concept of Non-Performing Assets (NPAs) may not be relevant for the mutual fund industry, and hence the guidelines for identification and provisioning of NPAs are deleted and replaced with securities classified as “below investment grade” or “default”.

The regulator has even gone on to define the treatment of accrued interest, future interest accrual and future recovery, in case of money market and debt securities classified as “below investment grade” or “default”.

If the mutual fund house makes a change to the terms of investment, which in turn may have an impact on valuations, the regulator has said that it will be required to be reported to the valuation agencies immediately.

There are many more facets and fine pointsthat SEBI has prescribed to value money market and debt securities.

The objective:

The broader objective of the aforesaid guidelines is to ensure that the mutual fund industry follows the best practices, whereby the robustness of valuation of debt & money market securities improves.

What if there is a deviation?

As per the principles of Fair Valuation specified by SEBI Mutual Funds Regulations, 1996, fund houses or AMCs will be responsible for true and fairness of valuation and correct NAV.

And in case if the AMC decides to deviate from the valuation price (given by the valuation agencies), the instance of deviation needs to be recorded along with detailed rationale for each by the AMC, going by the SEBI circular.

The impact on debt mutual funds…

Mutual fund houses would strictly adhere to these guidelines in the interest of their own risk management and to safeguard debt mutual fund investors. That being said, it does not make investing in debt mutual fund safe.

Remember, investing in debt funds is not risk-free.

How should investors approach debt mutual fund schemes?

Approach debt mutual fund schemes with your eyes wide open. Pay attention to traits of the sub-category of debt mutual fund scheme you are considering and its portfolio characteristics.

Prefer the safety of principal over returns. Stick to debt mutual funds where the fund manager doesn’t chase returns by taking higher credit risk. The fact is that many debt mutual funds across maturity profiles are grappling with downgraded and toxic debt papers which heighten the investment risk.

And last but not the least; assess your risk appetite and investment time horizon while investing in debt funds.

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