Debt Funds: Liquidity Matters, But Managing Liquidity Is The Key

Recently, I read an article written by an individual who is considered an expert on mutual funds. Weighing in on the ongoing debate of debt funds taking credit risk, he came up with an interesting solution--modify the structure of funds investing in illiquid securities, whereby redemption requests don’t have to be met immediately. The rationale being: the combination of investments in illiquid securities and an immediate redemption facility is at the root of the crisis. Hence the solution lies in permitting fund houses to make delayed redemptions. 

On the face of it, the recommendation seems reasonable. But scratch the surface, and the solution will appear simplistic. Here’s why:

To begin with, in a mutual fund, a portfolio manager’s role is not restricted to just identifying lucrative investment opportunities, and making timely investments. His ability to proficiently managing liquidity in the portfolio is no less important. Skilled portfolio construction can enable a manager to navigate unexpected market events (and handle redemption pressure) without unsettling the portfolio, or with minimum disruption to the portfolio. In other words, the presence of illiquid corporate debt in the portfolio need not make the portfolio illiquid. Indeed, liquidity management is one of the parameters on which the manager and his investment process must be evaluated. It is inexcusable for a manager to compromise the portfolio’s liquidity in a bid to clock higher returns. To my mind, such a scenario portrays the manager’s investment skills in poor light.

Furthermore, defining what constitutes a liquid investment is easier said than done. For instance, to suggest that only corporate bonds are illiquid wouldn’t be accurate. A cursory glance at data for trades in the benchmark 10-year GOI bond versus those for other GOI bonds reveals a telling picture. Market conditions and sentiment can significantly impact liquidity. In buoyant markets, the corporate debt segment can be more liquid than in a downturn. A parallel can be drawn for equity markets as well, wherein small/mid-caps typically tend to be more liquid during an upturn. Clearly, defining which funds invest in illiquid instruments (as has been suggested in the article) is more complicated than it has been made out to be.

Finally, there’s a need to discuss where the onus must lie: should investors be asked to tone down their expectations on the liquidity front, or should fund houses be responsible for performing better on the liquidity management front? 

In many ways, the financial crisis of 2008 proved seminal for the Indian mutual fund industry. Several debt funds (including close-ended products such as fixed maturity plans) witnessed extraordinary redemption pressure. Subsequently, SEBI put safeguards in place by prohibiting fund houses from providing premature redemption for close-ended funds and defining the investment profile for liquid funds, among others. Some fund houses and managers went back to the drawing board and re-evaluated their investment philosophy, especially for the debt funds segment. In turn, this equipped them to better manage liquidity in their portfolios. 

Present regulations governing redemptions are not only comprehensive, but reasonably indicative of how investments should be made. Hence, there is no valid reason for creating a third structure (a middle ground between open- and close-ended funds) to make up for a fund house/manager’s incompetence. As for fund houses which can’t make the grade, the ‘perform or perish’ maxim is apt. 

Investment Lessons From The JPMorgan Mutual Fund Episode

In the recent past, JPMorgan Mutual Fund has been in the news for all the wrong reasons. To begin with, it was reported that two of its debt funds i.e. JPMorgan India Treasury Fund and JPMorgan India Short Term Income Fund have suffered substantial losses on account of investments in an auto ancillary company—Amtek Auto. The latter is facing a financial crisis of sorts; in its communication with stock exchanges, it has mentioned a decline in operational performance, cash flow mismatch and steps being taken to counter the same. To further worsen matters, in Aug 2015, CARE (a rating agency) suspended its ratings of Amtek Auto stating that “the company has not furnished the information required by CARE for monitoring of the ratings”.

Expectedly such developments can hurt the price of the company’s debt issuance, and in turn the performance of mutual funds invested in these papers. Furthermore, the fund house decided to limit redemptions in the aforementioned funds “in the general interest of the unit holders”.

This entire episode has been curious to say the least. However, it offers some important investment lessons.

1. Evaluate the fund house’s character

Mutual fund investors are often guilty of not evaluating the fund house’s character before investing. This can prove to be a costly miss. The fund house’s character will go a long way in determining its policies, attitude towards investors and even the long-term performance of funds. While it would be unfair to draw conclusions on JPMorgan AMC based on a single incident, the asset manager’s decision to restrict redemptions does not portray it in a good light.

It must be clarified that the Scheme Information Documents of both funds explicitly state that the asset manager can restrict redemptions. Hence JPMorgan AMC’s actions are in line with stated policy. The trouble is that both funds are open-ended in nature wherein the implicit assumption is that investors are free to liquidate their investments at market price when they choose to do so. In the Indian mutual fund industry, this is the norm. On this count, the AMC has let its investors down. 

If investors in the fund are willing incur a loss, while liquidating their investments, that choice should be available to them. More importantly, if the AMC is truly concerned about investors’ best interests, it can compensate them for the losses incurred with their own monies. Conversely, limiting redemptions while they put their house in order amounts to penalizing investors for the AMC’s mistakes. A crisis will typically reveal true character, and in this case, JPMorgan AMC doesn’t come out smelling of roses. Hence it is pertinent that investors pay attention to the fund house’s character before investing. 

2. Debt funds are not risk-free investment avenues

A popular misconception suggests that debt funds are risk-free investment avenues. Admittedly, certain debt fund segments do expose investors to less risk versus say an equity fund. But treating them as risk-free investment avenues is plain erroneous. Being market-linked investments, debt funds are prone to risks such as interest rate risk and credit risk. Investors who wish to invest in risk-free instruments should stick to avenues such as small savings schemes (which are backed by a sovereign guarantee). 

Let’s focus on credit risk which is relevant to the case. Debt fund managers are known to take credit bets (invest in lower rated securities) to deliver outperformance. While the investment strategy is commonly deployed, as is often the case, some portfolio managers are more skilled than others, resulting in varying results. Clearly in the case of the two JPMorgan funds, the results were less than desirable.

It isn’t uncommon for some distributors and advisors to present debt funds as risk-free investment avenues. Irrespective of the reason – ignorance or mala fide intent – investors can and do end up being misled. Hence, they would do well to understand the true nature of debt funds before investing.

3. Participate in the investment process 

Yet again, this episode reinforces the need for investors to actively participate in the investment process. Admittedly, that is easier said than done. But investors should find motivation from the fact that their personal wealth is at stake. I’m not suggesting that investors become investment experts. Then again, being completely uninvolved is not prudent either.

For instance, while it helps to engage the services of an investment advisor, blindly acting on his advice isn’t recommended. Quiz him on his recommendations—enquire about the rationale, the risks involved, alternatives and how they stack up versus his recommendations. Additionally, it would help to read up about investing from independent and credible sources. The intention is to become informed investors. Apart from making better investment decisions, this will also help investors deal with testing periods in an assured manner.