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. 

Do you have a contingency reserve in place?

Does your investment advisor/financial planner recommend that you have a contingency reserve (or fund) in place at all times? Also, does he help you evaluate the adequacy of the same at regular time intervals? If not, then there might be a case for re-evaluating your association with the investment advisor/financial planner.

Simply put, maintaining a contingency reserve amounts to saving for a rainy day. Alongside creating portfolios to meet goals like retirement and children's education, having a contingency reserve in place is equally important. As the name suggests, this is a pool of money set aside to provide for unforeseen events. While the concept of maintaining a dedicated reserve for the aforementioned purpose isn't exactly a recent phenomenon, its need has certainly become more pronounced now, thanks to the layoffs, pay cuts and enterprises shutting shop.

A contingency reserve ensures that you can go about with your day-to-day activities even in the event of an unexpected (and unpleasant) situation arising. In effect, it ensures that you don't have to compromise on your lifestyle, even in difficult times.

How much money will I need
Like investing, creating a contingency reserve is also a personalised activity i.e. it has to be tailor-made for you. What you need to do is determine how much money you need to meet all your expenses on say a monthly basis. This will include making an estimate of all expenses i.e. grocery bills, utility bills (electricity, telephone, petrol, rent and EMI), outlay towards children's tuition fees, among others. Activities like dinners in restaurants, weekend getaways, movies and shopping sprees at malls should also be provided for. You might also want to incorporate a certain amount for medical emergencies, given how expensive hospitalisation and medical treatment can be (remember, medical insurance doesn't cover all ailments). While theoretically the list can be endless, you need to arrive at one that is right for you. It should comprehensively cover all the areas that you would need to spend on in the normal course, and thereby ensure that your lifestyle is not dented.

The next step is to determine the period for which you would like to make a provision. Again, this choice needs to be made, based on what works for you. Suppose you arrive at Rs X as the sum that you need to spend every month; furthermore, you believe that 6 months is the period for which you would like to have a 'safety net'. In that case, you should have a contingency reserve of Rs 6X.

How to create a contingency reserve
It's possible that you may not have the requisite sum (Rs 6X) available at your disposal, to begin with. That's fine. Set aside what you have and keep adding to it in a disciplined manner until the target is achieved. It is important that the contingency reserve be invested in appropriate avenues. Safety and liquidity are two factors that must be accorded high priority. Hence, the sum can be stored in a separate (more on this later) savings bank account; a portion of the reserve can even be held in cash. The intention is ensure that the earmarked funds can be accessed at a short notice and also, that they are not exposed to any risk.

The contingency reserve is sacrosanct
It is vital that you respect the sacred nature of the contingency reserve. In some cases, the sum being set aside can be quite substantial. There will be temptations to dip into the reserve and use the monies for purposes, other than the intended ones. For instance, if equity markets are surging, a substantial sum of money lying unutilised in a savings bank account may stick out like a sore thumb; there will be temptation to invest those monies in the markets. When it's the festive season, attractive discounts are commonplace. You might be tempted to use the reserve to capitalise on the same. Don't succumb to such temptations. It would certainly help to hold the contingency funds in a separate bank account. Thus the likelihood of the funds getting used up for extraneous purposes will be reduced.

Finally, at regular time intervals, it is important that you review if the contingency reserve is adequate. An upgrade in your lifestyle could mean that the contingency reserve has become inadequate. In such a scenario, replenishing the same at the earliest should be given priority.

In a time of crisis, not having a contingency reserve could force you to either compromise on your lifestyle or divert monies from other needs. In either case, it would be an undesirable scenario. Several individuals are vulnerable to the "it will never happen to me, so why provide for it" syndrome. While it would be nice to be never faced with a crisis, banking on the same might amount to wishful thinking. Remember, the rationale for a contingency reserve can be traced to the time-tested tenet of - prevention being better than cure.