Ind-Ra has outstanding ratings on mutual fund schemes across categories, including overnight funds, liquid funds, money market funds, ultra-short term funds, low duration funds and banking & public sector units (PSUs) debt funds. The ratings are an opinion on the vulnerability to losses as a result of defaults in a bond fund portfolio. Fund credit ratings do not comment on the funds’ ability to meet timely redemptions to unitholders or its ability to meet the expected returns. Rather, they are based on the actual average credit quality of the fund’s invested portfolio.
Ind-Ra rated schemes have maintained adequate credit quality commensurate with their rating levels, although some of their assets under management (AUMs) are witnessing sharp reductions due to redemptions. While the credit quality and duration of the underlying investments of a scheme primarily drive the rating, Ind-Ra considers the liquidity, diversification of portfolio in terms of sectors and entities as well as maturity profile of the underlying investments for qualitative rating adjustments. Ind-Ra understands that weak liquidity and significant investor redemptions may increase risks in the scheme portfolio by way of increasing concentration over entities and sectors. The weak liquidity conditions in the secondary market often lead to the selling of top quality investments in the portfolio to honour the sustained redemption pressure, and the same may adversely affect the credit quality and liquidity of the retained portfolio.
Ind-Ra considers a portfolio with single entity concentration at 15% and the top 5 entities at 50% to be moderately concentrated. The agency monitors its rated schemes on a regular basis and is currently reviewing the portfolio in terms of the credit quality of the underlying investments as well as diversification to manage concentration risks and may take rating actions on the mutual fund schemes that are holding securities in high concentration on a sustained basis.
Market Condition & Impact on AUM: All the rated schemes showed a drop in AUM in March 2020, which is a common trend among debt mutual funds because of fiscal year end. However, the change in AUM from January to April 2020 shows that there have been net outflows from most funds and AUM is yet to stabilise amid the COVID-19 impact.
The agency believes that the various steps taken by the regulators to alleviate the liquidity risk in the system & money market including encouraging bank credit lines to mutual funds have been effective to check significant worsening of the condition. In absence of market normalcy and stability, debt mutual funds may continue to face multiple headwinds.
Banking System Liquidity: On the bright side, liquidity in the banking system has remained remarkably high, largely through open market operations and regular infusions through various kinds of repo windows. As a consequence, the average net liquidity lately had been close to INR5 trillion and gross reverse repo amount has been clocking over INR7 trillion. However, high risk aversion and uncertainty regarding scope and timeline of recovery have been the major obstacles to convert such liquidity into meaningful lending.
Skewed Secondary Market Activities: Market liquidity conditions, on the other hand, have been on tenterhooks. The activity in the primary and secondary markets for commercial papers (CPs) demonstrates a preference for few entities with low risk perception. The agency believes the availability of liquidity for NBFCs and HFCs has been on a low, due to elevated perception risk largely to do with the lack of confidence on specific entities or over the sector as a whole. This elevated risk aversion would be detrimental for debt mutual funds as some of the rated schemes have significant exposures to the NBFC/HFC sector.
Activities in the secondary market have been severely impacted, because NBFCs and HFCs as issuers have been large contributors to the CP market. The daily CP trades in the secondary markets is less than 1% of the total outstanding amount and around 1% of the total exposure of debt mutual funds in CPs. A diminished secondary market activity is a major worry for open-ended debt mutual funds. Due to redemption pressure, fund managers may be forced to sell the best quality investments and this may leave the portfolio with relatively illiquid and weaker quality assets. Ind-Ra believes this is credit negative for mutual fund rating.
Frequent Refinancing Poses Systemic Challenges: Driven by the rising uncertainties, asset managers have shortened their duration of assets, notwithstanding the falling interest rates. This is legitimate for fund managers’ risk management. On the other hand, it raises risk of refinancing for borrowers.
Concentrated Investors Exacerbate Redemption Pressures: The source of flows to liquid funds has largely been concentrated at corporates (76%). Ind-Ra believes in the absence of diversified sources, reliance on one category of investors could be risky in the near term. The lockdown has adversely impacted corporate cash flows and short-term investments. Corporates will require a considerable amount of working capital to kick start production and other activities. In such a scenario, there could be a rush to liquidate existing investments in liquid mutual funds, leading to a further rise in redemption and concurrent challenges.