How Mutual Funds can redeem themselves from the Amtek and JSPL disasters

Over the last year, we have seen two major issues in the debt mutual fund market resulting from corporate debt defaults. The first issue arose when Amtek Auto defaulted on its bonds and JP Morgan AMC, which held a significant amount of these bonds, temporarily suspended redemptions on the fund. More recently this week, Jindal Steel and Power Limited (JSPL) has been downgraded to junk as it is expected to default on a 37,000 crore bond issue. Franklin Templeton and ICICI Prudential were caught with a significant share in this bond.

The trouble with JSPL started with Crisil downgrading the JSPL debt from BBB+ to BB+ on the 17th of Feb and then further downgrading it from BB+ to D on the 10th of Mar. Crisil definitely owes an explanation as to how they decided to cut the rating by only a couple of notches just 3 weeks before rating it as junk.

But, the more serious concern here is how the mutual funds are dealing with these situations. The word in the market is that ICICI has still not marked down its books as of the close of 10th Mar.

There was a message from ICICI Prudential AMC floating around on Twitter yesterday.

This statement is shocking to say the least. I would be seriously worried if my debt fund valued its portfolio based on their friendships and past experience with the company instead of credit ratings and the actual market prices.

The case of the Amtek Auto default and the reaction of JP Morgan AMC was even more bizarre, with the fund deciding to stop redemptions.

The Problem

The crux of the problem is the fact that there is no easy way for an investor or even a knowledgable financial advisor to independently value a portfolio and check if the NAV reflects the true value of the portfolio.

The AMCs refuse to mark down the NAV as the bond has not traded in the market and they continue to value it at the last traded price before the rating downgrades happened.

As is the case with any financial instrument, the person who suffers the most is the retail investor.

The lack of liquidity of one of the instruments has been cited as an extraordinary situation and redemptions are stopped, as was the case with JP Morgan.

If they don’t stop the redemptions and continue to carry the faulty NAV, the investors who are more aware (typically institutions and HNIs with knowledgable advisors) redeem quickly at the higher NAV. As a result, they dump their share of losses resulting from the downgrade on the investors who are unaware of the situation and still hold the fund (typically small retail investors who don’t understand the credit markets).

Is there a solution to this problem?

The ‘ideal’ solution is to trade all credit instruments on an exchange. Then like the price of equity shares, there is a way for market participants to discover the right NAV for the debt mutual fund as they do with the equity mutual funds.

However, this solution is not workable. There are several pros and cons of moving credit trading to exchanges, with the cons outweighing the pros. That is why globally credit is traded in the OTC markets.

But there is one solution, which although not ideal, is workable, practical and can significantly improve the protection available to small retail investors.

While trading credit instruments on an exchange is not practical and unlikely to happen in the near future, trading credit products on an exchange is very practical and easily done.

Enter the ETF

ETFs are similar to Mutual Funds but work slightly differently from a typical Mutual Fund. Let us take the case of a fund where the NAV is 1,000 rupees. With a Mutual Fund, any person can go to the AMC and offer 1,000 rupees to buy a unit of the fund. With ETFs, the AMC will only create or redeem (sell or buy) only in multiples of say, 10,000. This implies that one needs to have a crore of rupees to go to the AMC and buy the fund. The buy and sell trades with the AMC are therefore done only by specialists called market makers. These market makers then use the 10,000 units of the ETF to buy and sell units on a stock exchange in multiples of 1.

When a market maker goes to the AMC to buy these 10,000 units of the ETF, he doesn’t offer a crore in cash, instead he delivers a crore worth basket of underlying instruments (bonds) in the same proportion as they are in the ETF and exchanges it for units of the ETF. Therefore, there is no cash involved in the transaction — it is bonds for units of ETF. Even when he sells the ETF back to the fund (redeems), the AMC exchanges the units of ETF for bonds that are in the ETF and pays no cash to the market maker.

How ETFs can address our concerns

Imagine debt mutual funds being sold on the exchanges packaged as ETFs. With a strong market maker who is willing to buy and sell at any point of time, the two problems discussed above can be addressed.

Market makers ensure that investors always knows the fair price of the ETF and are able to transact at that price.

Let us first consider the situation where the redemptions are stopped by the AMC. This doesn’t necessarily mean that the market maker would not be willing to buy on the exchange. The market maker typically is a person with the best access to information on the true value of the underlying credit instruments. This market maker also always has the opportunity to hedge his own exposure by trading in the underlying bonds. So the market maker will continue to buy on the exchange at a price that is lower than the NAV, but reflects what he believes is the true value of the underlying basket, plus a small profit for himself. He will accumulate the ETF at this lower price and redeem the ETF when the AMC resumes redemptions.

In the second case where the AMC doesn’t stop redemptions and continues business as usual, the market maker can help the retail investor access the same value as a HNI or an institution.

Let us take the case of a bond fund with a NAV of 1,000. Let us say the fair market price, according to the market maker, is 990. The market maker can value the fund at 990 even before a rating downgrade as he has all the relevant information from the credit markets.

The market maker in this case simply buys the underlying bonds in the market for 990, exchanges it for ETFs and sells them in the market, say at a price of 995, which is lower than the NAV.

Since the price is lower than the NAV, there would be demand for the ETF and this will result in the fund accumulating more and more of the troubled bond at an artificially high price. Anyone who unknowingly buys these ETFs in the market is going to see a massive loss as soon as the downgrade happens. This is obviously an undesirable result for the fund manager as the mutual fund’s reputation would be at stake.

To avoid this situation, bond fund managers will be forced to mark the NAV at the fair price of 990 immediately to avoid increasing the AUM of the fund as a result of a artificially high NAV.

Turning bond funds into ETFs ensures that every buy or sell trade that the fund does on the ETF is with a market maker as capable of valuing the underlying bonds as the fund manager.

ETFs therefore ensure that everyone downstream who owns the fund is treated equally and everyone suffers a loss that is proportionate to their holdings, bringing the retail investor on par with the institutions and HNIs.

This is not just a theoretical construct. There are about 300 bond ETFs in the US with a total AUM of about $400 billion. This number is almost twice the AUM of all Indian Mutual Funds under every asset class put together.