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Last month, SEBI had asked credit rating agencies not to consider any delay in payment of interest or principal loan amount arisen solely due to the nationwide lockdown conditions as a default.

The stress in the Indian mutual fund industry due to the pandemic impact deepened after Franklin Templeton MF decided to wind down six of its debt schemes. The lack of liquidity and redemption pressure compelled FTMF to take the extreme step.

In this economic environment, Mutual Fund houses are concerned about companies that are likely to delay and default in payments. Many companies have sought deferment/rescheduling of payment due to COVID-19 related disruptions. In order to minimize the resultant damage, market regulator SEBI recently provided temporary relaxation in valuation norms for instruments mutual funds hold.

SEBI has asked valuation agencies to avoid treating delays in payment of interest/principal or extension of maturity of a security as default for the purpose of valuation of money market or debt securities held by Mutual Funds, if it has been caused solely due to COVID-19 pandemic lockdown and/or in light of the moratorium permitted by RBI.

[Read: Will Mutual Fund Houses Act Against Companies Approaching Courts To Prevent Rating Downgrade Amidst COVID-19?]

"In view of the nationwide lockdown and the three-month moratorium/ deferment on payment permitted by RBI, a differentiation in treatment of default, on a case to case basis, needs to be made as to whether such default occurred solely due to the lockdown or loan moratorium", SEBI circular said.

SEBI has stated that in the above mentioned scenario, if there is any difference in the valuation of securities provided by two valuation agencies, the conservative valuation shall be accepted. This revised norm will be in effect until the RBI's period of moratorium.

However, AMCs shall continue to be responsible for true and fairness of valuation of securities.

Mutual fund houses have to mark the value of their assets based on valuations provided by valuation agencies appointed by AMFI.

At present, a debt or money market security is classified as 'Default' if the interest and/or principal amount has not been received on the day such amount was due; or when such security has been downgraded to 'Default' grade by a credit rating agency. Default denoted that the security is below investment grade.

This leads to mark down of the respective security and thereby impacts NAV of the scheme.

SEBI's move provides some relief in this regard. It will ensure that all fund houses follow a uniform approach while dealing with defaults/delay due to COVID-19.

Will it make investment in debt fund safe?

SEBI has not yet provided any moratorium on commercial paper and corporate bond repayment. According to a report published in Livemint, Rs 1.5 trillion worth of commercial paper and corporate bonds will be maturing in the first quarter.

As mentioned earlier, AMCs shall continue to be responsible for true and fairness of valuation of securities. But in the absence of rating downgrade from valuation agencies, fund houses cannot side-pocket their exposure to a defaulting company. Therefore, we may still see some write-offs if the AMC finds recovery to be difficult even after the relaxation period.

COVID-19 has impacted businesses across sectors. Some sectors such as NBFCs were under stress even before the pandemic. The default risk has thus amplified.

The relaxation of valuation would delay the issue, but downgrades would arise subsequently. Spike in number of side pockets (by fund houses) may thus become imminent.

My colleague, Rounaq, rightly mentioned yesterday, losses the investors suffer will be directly proportionate to the stress, pressure mutual fund houses and their investors will face. Eventually retail and High Net-worth Individuals, particularly, will lose confidence and may not be keen to invest in debt funds.

What should investors do?

In these uncertain times, it would be wise sticking to liquid funds and overnight funds for the fixed-income part of your portfolio and avoid funds that take higher credit risk. Alternatively, if you prefer safety of capital, invest in Bank fixed deposits.

Choose a fund house that follows prudent investment process and stringent risk-management system.

Our friends at Quantum Mutual Fund have highlighted the secret behind their debt management strategy, which has helped them provide safety and liquidity to investors when it comes to investing in quantum funds. Don't Worry, Quantum Liquid Fund always aims for Safety and Liquidity.

SEBI has time and again taken steps to tighten norms for debt funds. As an investor, if you take portfolio risks, align it with your own risk appetite and financial objective.

PS: If you wish to select worthy mutual fund schemes, I recommend you to subscribe to PersonalFN's unbiased premium research service, FundSelect.

Additionally, as a bonus, you get access to PersonalFN's popular debt mutual fund service, DebtSelect.

If you are serious about investing in a rewarding mutual fund scheme, Subscribe now!

Author: Divya Grover

This article first appeared on PersonalFN here.

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PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

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