Covid effect? Debt Mutual Funds to face multiple headwinds

Since the lockdown was imposed in India to contain the spread of novel coronavirus, weak liquidity of underlying assets and redemption pressures have been a risk to the debt mutual funds.

Since the lockdown was imposed in India to contain the spread of novel coronavirus, weak liquidity of underlying assets and redemption pressures have been a risk to the debt mutual funds. India Ratings & Research believes that in the absence of market normalcy and stability, debt mutual funds may continue to face multiple headwinds.

Last month Franklin Templeton Mutual Fund closed its six debt schemes due to significantly reduced liquidity in the Indian bond markets for most debt securities and unprecedented levels of redemptions following the novel coronavirus outbreak and lockdown.

The rating agency said it recognised that weak liquidity and significant investor redemptions could increase risks in the scheme portfolio by way of increasing concentration over entities and sectors. “The weak liquidity conditions in the secondary market often lead to the selling of top quality investments in the portfolio to honour the sustained redemption pressure, and the same may adversely affect the credit quality and liquidity of the retained portfolio,” said rating agency in its press release on Thursday.

Some of the debt fund categories have been witnessing fall in assets under management (AUM) since 2019, followed by a period of weak growth. The rating agency was of the view that the redemptions were largely a consequence of the weak balance sheet liquidity of corporates which has aggravated during the lockdown. The contributions from corporates in liquid funds and credit funds have dried up.

The data from Association of Mutual Funds in India (Amfi) shows that liquid funds have seen net outflows of Rs 25,332.19 crore in the first four months of the current calendar year. In March, liquid funds had seen sharp outflows to the tune of Rs 1.10 lakh crore. While credit risk funds saw net outflows of Rs 19,238.98 crore in April as investors pulled out money after the Franklin Templeton MF closed its debt schemes. The net AUM of credit risk funds as on April 2020 stood at Rs 35,222.36 crore compared to Rs 79,643. 89 crore in April last year, a fall of Rs 44,421.53 crore.

Activities in the secondary market have been severely impacted, because non-banking financial companies (NBFCs) and housing finance companies (HFCs) as issuers have been large contributors to the commercial papers (CP) market. “The daily CP trades in the secondary markets is less than 1% of the total outstanding amount and around 1% of the total exposure of debt mutual funds in CPs. A diminished secondary market activity is a major worry for open-ended debt mutual funds,” said the rating agency.

Due to redemption pressure, fund managers may be forced to sell the best quality investments, and this may leave the portfolio with relatively illiquid and weaker quality assets. The challenging secondary market operating environment coupled with bouts of redemption pressure could sharply deteriorate the portfolio quality. “These challenges could be aggravated amid further deterioration in macro-conditions and any idiosyncratic credit event,” added India Ratings & Research.