SEBI’s new debt fund regulations: Impact on Investors

Author: Neelesh Meena, second-year student at the National Law University Odisha

‘Investor Protection’ continues to dominate as a regulatory objective internationally, but is still very controversial reasoning for an intervention by the regulatory authority of a country. Sharp distinctions arise between characterizations of investor protection as, a threat to entrepreneurialism and efficient capital raising, as an expression of social virtues and as a moral imperative. The retail investor has been cast as a central figure in contemporary capitalism, forming a part of a wider cultural legacy which dates to nineteenth-century globalization, But the retail investors can also be regarded as a disruptive force.

The regulations imposed by SEBI makes the debt securities more transparent and safe particularly for long-term investors and may not work wonders for short-term investors. It makes debt securities non-profitable for short-term investors and will even cost more owing to the newly imposed exit load. Prima facie, the regulation by SEBI looks restraining to the retail investors and their market behaviour may affect the valuations the debt securities.

SEBI has imposed new regulations on debt securities to protect the interest of investors from credit and liquid risk. This comes after the liquidity crunch which was started by NBFC crisis which led IL&FS group of companies to default huge amount of loans.  The defaulted payments of IL&FS led to the credit crunch in the economy. Many debt security funds invested in IL&FS group of companies and similar companies without assessing the risk associated with it for higher returns. Several instances similar to this led MFAC (Mutual Fund Advisory Committee) to recommend SEBI to impose such regulation on Debt securities. The regulations are:-

a)    Mandatory Liquid Assets: The Debt securities shall hold at least 20 per cent of the portfolio in cash, T-bills or government securities. This will ensure that Debt securities become more liquid and making the investors’ money more secure.

b)   Sector Exposure Cap reduced: The investment to a single sector is decreased to 20 per cent from 25 per cent. The exposure to HFCs (Housing Finance Companies) is also reduced to 10 per cent. The move comes to prevent highly concentration from a portfolio which may harm investors in the long-term.

c)    Mark to Market Valuation: The debt funds are now having to be regulated mandatorily by mark to market valuation. Earlier, Mark to method valuation method was only compulsory for securities over 60 days of maturity, now the bar has been reduced to 30 days. The amortization basis of valuation which was in practice earlier showed a linear growth. On the other hand, the mark-to-method valuation will show the growth of funds in a very realistic manner.

d)   No Structured obligation: Overnight schemes and liquid schemes will not be allowed to invest in structured obligations like debt obligations with credit enhancement.

e)    Exit load on Liquid Funds: A exit load is introduced on exiting liquid funds within seven days of investing. Investors use debt securities to park their money for a very short period. The speculation of the exact consequences is hard as the exact rate of exit load is yet to be declared by SEBI.

f)    Four times cover required for investing in Mutual funds: For debt securities to invest in Mutual funds, it is mandatory for the mutual funds in which they are investing to have a credit enhancement of four times which are backed by equities directly or indirectly.

g)   Only listed NCDs and CPs: Mutual funds will only be allowed to invest in listed Non-Convertible Debentures and Commercial Papers. As of now, there are no listed Commercial papers in India so the implementation of this regulation would take some time.

Impact on Investors

The implementation of the new norms by SEBI may not be welcomed by investors as they are resulting in highly liquid debt funds to fluctuate more and yield fewer returns to the investors. However, these norms make debt securities safer and more liquid which would be beneficial to long term investors.

The valuation of debt securities shall be solely based on mark to market methodology. It will keep the prices of the securities closer to reality but will make the price fluctuations common which the investors don’t like in debt securities. The use of the mark to market methodology adds volatility to the security which in turn will increase the price fluctuations.

The reasons for the increment of volatility in debt securities is due to the fact that the AUMs are now compelled to put at least 20 per cent of the fund in liquid assets such as cash, T-bills. Government securities, etc. This will prevent the liquid securities from falling too much when a contraction occurs in the secondary market. The volatility of liquid securities makes them vulnerable to everything happening in the market.

The sectoral cap of shall also be reduced from 25% to 20% and they will not be allowed to invest more than 10 per cent of the assets in debt securities which carries credit enhancement. The mutual funds are also mandated to have a security cover of 4 times of their investment in the debt securities having credit enhancement that shall be backed by LAS. (Loan against shares)

The regulation of sectoral cap will make the debt securities more diversified and will act as a restraint so that investment in riskier securities can be prevented. Good investment managers do not involve in such activities but recent episodes’ over-exposure to troubled papers urged SEBI to regulate Debt securities. The move will make debt securities more diversified and safer.

SEBI has implemented an exit load for debt securities on redemptions within a period of seven days. The move was highly improbable by the regulator as Debt fund is usually used by the retail and institutional investors to park their idol money which may be a short period of days, usually less than a week. This will stop investors to use these funds to park their idol funds and will probably make them shift to overnight funds. However, the exact consequence is still difficult to predict as the percentage of the exit load is yet to be released by the regulator.

The new regulations will ensure that the money invested is managed safely by mutual fund companies and it is a win-win situation for long term investors but these regulations imposed contribute drastically towards the increment of volatility of the securities which is not a good thing for a debt security as it defeats the purpose of it and why it is used by the investors on first hand.

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