Sebi urges mutual funds to stop relying solely on credit rating firms

Regulator asks funds to develop internal credit appraisal systems to reduce the reliance on rating agencies

India’s capital market regulator has asked asset management companies (AMCs) to stop depending entirely on credit rating agencies to assess corporate bond investments in their portfolios.

At a meeting between officials of the Securities and Exchange Board of India (Sebi) and the Association of Mutual Funds in India (AMFI) on Tuesday, the regulator asked mutual funds to develop internal credit appraisal systems to reduce the reliance on rating agencies, said two people who attended the meeting. They declined to be identified.

Rating agencies have been criticized for sharp and sudden downgrades of corporate debt, which led to a hit on the fixed income portfolio of mutual funds. For instance, a downgrade of Amtek Auto Ltd bonds led to a redemption crisis at JPMorgan Asset Management Co.

Following such instances, the market watchdog warned AMCs to avoid taking undue credit risks by investing in debt papers of companies that are saddled with loans and could face potential rating downgrades.

Fixed income securities worth Rs.4000 crore held by AMCs at the end of July were downgraded, according to data shared by Sebi at Tuesday’s meeting with AMCs. At August end, this number went up sharply to Rs.13,000 crore, showed Sebi’s data.

Sebi told AMCs that the data points to the need for caution, the two people said.

Sebi officials said the industry must work on ways to strengthen their credit appraisal systems and put in place adequate risk management capabilities to manage fixed income schemes, said on of the people.

“Sebi was of the view that the industry has been building scale by launching a number of schemes but the industry may be facing a reputational risk due to its exposure to debt papers of companies that are being downgraded,” the person said.

Sebi is asking funds to do what they should be doing anyway, said Dhirendra Kumar, chief executive officer of New Delhi-based Value Research, a mutual funds tracker.

“This kind of research should be the core activity of every fund,” Kumar said. “I think every bond investor knows well that the rating agencies can’t be relied upon.”

There are 44 mutual fund houses in India managing assets worth Rs.12.28 trillion at the end of June. The assets of credit opportunities funds, which face the maximum risk from downgrades to corporate bonds, stood at Rs.67,622 crore at the end of August, according to Crisil Ltd, a rater.

“If the balance sheet of an AMC is good, it can take such risks of value erosion in its schemes, but Sebi wants AMCs to ensure that the industry’s reputation is kept intact,” the second person said.

Recently, Sebi asked AMCs to explain the rationale behind their corporate bond investments, as it sought to avoid a redemption crisis similar to the one faced by JP Morgan AMC. Two schemes of the fund were hit because of a Rs.193 crore exposure to bonds of Amtek Auto, which were downgraded by rating agencies because of the company’s deteriorating financial situation.

The AMC was forced to restrict redemptions from the two schemes. However, last week, JP Morgan split units in these schemes into two: one for Amtek Auto securities, the other for all its other investments.

The root of the problem is more fundamental, Kumar said.

“Fundamentally, AMCs with Sebi’s concurrence are running open-end funds on top of corporate bonds, most of which are fairly illiquid. This contradiction at the heart of the debt fund industry has to be examined by the regulator,” he said. “Procedures and processes such as the valuation matrix and redemption norms should also be given a close look.”

The mutual fund industry has an exposure to corporate bonds of at least 275 listed companies, according to Value Research.

At Rs.13,177.88 crore, Franklin Templeton Mutual Fund has the highest exposure to corporate bonds. This is followed by HDFC Asset Management Co. Ltd with an exposure of Rs.12,563.19 crore, and ICICI Prudential Asset Management Co. Ltd with an exposure of at least Rs.6,043.57 crore.

HT Mint, New Delhi, 1st Oct. 2015