The closure of six “yield oriented” schemes on April 23 by Franklin Templeton is an event that has been in the making for many years. Along with it being a failure of an asset manager to fulfil obligations to investors, it brings to the fore the risks associated with navigating India’s largely illiquid debt markets. While market participants and experts have reached out to portray this as yet another one-time event, it highlights the basic contradiction in India’s prevailing debt-fund structure.
Most debt-fund schemes are structured to provide high levels of liquidity to investors. In fact, this is one of the advantages highlighted most often. Investors are told they can get their money back any time they wish while generating a competitive return, an assertion which becomes a reason for them to invest in these funds.
Yet, periodically, debt funds find themselves unable to provide the promised liquidity. This is because of the lack of liquidity in the underlying debt market. Events of this nature were experienced in 2008, 2013, and most recently, over the last month. Despite these events, the mutual-fund (MF) industry has done nothing to fix the fundamental flaw in the product offering: the offer of significantly higher liquidity than the underlaying asset class.
Offering more liquidity than available
Even in normal market conditions, liquidity in debt markets is extremely conditional. It is available in some instruments of some issuers, provided they meet the conditions that market participants insist on. Moreover, these conditions keep changing. This makes liquidity forecasts inherently flawed. Yet, despite an almost universal acceptance of this fact, the MF industry continues to use examples of debt-fund offering in highly developed markets as a justification to offer similar facilities in India, without the required institutional infrastructure.
This ability of MF schemes to offer more liquidity than that available in the asset class they invest in, is possible because an open-ended MF scheme can get inflows every day to fund possible investor outflows. As a result, the scheme only needs liquidity from its portfolio to fund net outflows, which are typically much smaller than total outflows. In addition, regulations allow MF schemes to borrow as much as 20% of their assets to fund outflows, which further reduces the liquidity demanded from the portfolio on any given day. This arrangement works quite well. Till it doesn’t.
Most debt MF portfolios, in isolation, can survive short periods of inflow disruptions. Outflows can be funded from borrowings till such time that inflows happen, or portfolio holdings are sold. In case of the latter, under normal market conditions, for almost every fund with net outflow, there may be one with a net inflow.
However, if market conditions deteriorate, compelling investors to move out of debt funds in general or a certain fund category in specific, it is entirely possible that there will be no buyers for the assets, and all these schemes will need to sell. This is especially true if these schemes invest in an asset type that no other market participant is comfortable with, like low-rated debt.
However, the possibility of this happening isn’t just restricted to a particular debt MF, it applies to all.
Possible remedies
All open-ended debt schemes offer more liquidity than the asset they invest in and this makes them vulnerable to disruptions in market liquidity. It is a reality that all stakeholders must accept. There are deep changes required in the structure of debt mutual funds at the earliest.
The liquidity available to investors in debt schemes needs to reduce to come closer to that of the underlying asset class, which will help portfolios survive inflow-liquidity disruptions over longer periods. This is the only way the MF industry will be able to earn back some of the credibility it has lost over the last few years.
However, this isn’t all. Urgent measures are required to increase the liquidity available in the debt market to bring it closer to that required by products that Indian investors deserve. For this, the debt market must undergo deep reforms to address the inconsistent and conditional liquidity that plagues it.
The consequences of conditional illiquidity are manifold. It makes market participation an inherently complex undertaking, with expert knowledge needed to navigate its inconsistency. By virtue of this complexity, Indian debt markets are almost entirely institutional in nature. Even among institutions, most non-financial institutional investors hesitate to participate in this market directly despite having the size to do so. This is partly due to the complexity itself and partly due to the artificially simple products offered by MFs.
As a result, the number of investors participating directly in the debt market is exceedingly small. These include banks, insurance companies, mutual funds, and primary dealers, and a handful of non-financial investors. Most disturbingly, since an overwhelming number of these are financial-sector participants, they have similar incentives and pressures, which frequently result in “herding”: circumstances in which all participants in a market are inclined to either sell or buy, resulting in large swings in asset prices and frozen markets.
As such, it is imperative that participation in the debt markets is widened to include participants with diverse profiles and incentives, including both institutions and individuals. The only way this will happen is by remedying its characteristic inconsistent liquidity conditions.
The next part of the series will focus on the efforts made by regulators to deepen the bond markets to encourage wider participation and will explore the reasons for their lack of success.
(The author is an economist, debt-market specialist, and the former CEO of Essel Mutual Fund.)
via The Franklin Templeton fiasco exposes the underlying risks of India’s debt market – ET Prime
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