RBI offers cushion to shaky debt mutual funds

Genesis.

Last week, Franklin Templeton Mutual Fund shut six of its high-yield credit funds. The shutdown was majorly attributable to continuously thinning volumes in the high-yield fixed income securities segment and incremental redemption pressure given the current state of our pandemic-stricken markets.

Contagion?

While the Franklin Templeton episode is largely considered as a one-off event, there is an equivalent and pronounced worry about more funds packing up soon. However, one point most seem to miss that the threat looming over the FT funds was that of liquidity which emanated from an aversion to credit risks – which was anyway around since the IL&FS crisis.

Because of the pandemic-struck economy, investor perception of credit risk worsened considering the additional stress on already stressed companies with sub-AAA rated debt. Lack of buyers led to a lower trading volume, hence creating a problem for Franklin Templeton Mutual Funds holding such papers when they could not sell holdings to meet redemption requirements.

What’s RBI doing here?

Like Franklin Templeton, there’s a possibility that other mutual funds may face a similar situation where liquidity is too thin to be able to offload holdings to meet redemption requests.

To help contain mass panic and support mutual funds, RBI announced a liquidity facility of INR 50,000 Cr. Mutual Funds can dip into this facility and try tiding over the situation before succumbing to the pressure and moving funds into liquidation – which will lead to further deterioration of markets & investor sentiment.

Mutual fund may need money in their hand in case of extreme redemption pressure. It is the preventive measure and not that every mutual fund faces the redemption pressure.

How does this work?

Like every other measure, this is not so straightforward. Under this facility, the RBI will provide funds to banks at lower rates and banks then can access this money to exclusively meet liquidity requests by mutual funds.

Banks can extend loans to mutual funds, undertaking outright purchase of and/or repos against the collateral of investment grade corporate bonds, commercial papers (CPs), debentures and certificates of deposit (CDs) held by mutual funds.

The RBI shall conduct repo operations of 90 days tenor at the fixed repo rate. This liquidity facility is on-tap and open-ended, and banks can submit their bids to avail funding on any day from Monday to Friday (excluding holidays).

What should a debt fund investor do?

While RBI’s intervention offers sufficient cushion to mutual funds to ensure the FT episode is not replayed in another form by any other fund house, it is essential an investor must shift allocation towards much safer sovereign and AAA-rated (higher sovereign preferred) debt funds at least till there’s more clarity around the state of the economy.

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