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FMPs can't be redeemed, have to trade on exchanges

SEBI’s new ruling:

3. It was decided that no early exit will be allowed in any scheme of Mutual Fund in the nature of a close ended scheme. The schemes which have been approved earlier but not yet launched will also have to be amended accordingly. It will be obligatory for the Asset Management Company to list the close ended schemes. The Board also decided that for such close ended schemes the underlying assets will not have a maturity beyond the date on which the scheme expires.

With no redemptions in closed ended schemes, investors cannot choose to exit early – they have to stay the distance. The listing on exchanges provides a secondary exit option; but if there are no buyers, this door will also be closed. This option, though, may provide a trading opportunity : a buyer with a longer term horizon can pick the FMP at lower prices, and at a better pricing of the risk.

But the second part is worse – underlying assets cannot be greater in term than the expiry. Meaning, a three month FMP has to buy a three month (or lesser) debt product and one year FMP, nothing more than a year’s maturity.

You might think this is so obvious it’s blinding. If you have to give back money in a year, why the heck would you buy a product that has a longer maturity? For one, there’s liquidity – the 2018 Government securities are enormously liquid, but you will find few buyers for a one year Reliance bond.

And another is the simple formula of enhancing short term products with long term yields. Say I buy a product with a five year maturity for a one year FMP. After a year, I create another 1-year FMP, and sell from the earlier FMP to the new one, at a price that reflects one year’s interest. And so on.

Another way is to transfer a longer term asset from a bank’s books to the FMP, and then back. Say a bank has a number of SLR-able bonds – G-Secs – which they don’t need any more because the SLR has been cut. It sells them to the FMP at a market price. This is where things get a little shady; when you see longer term interest rates coming down, you know that prices of such bonds will increase. ANd the increase is substantial – a drop of a long term bond yield from 7.5% to 6.5% can bring the price up by 7%! Add that to the yield itself and you have got yourself a near 15% return, on 1% change in yield.

But the FMP may have “indicated” only 10% to its customers – so the bank can buy back the bond in one year, at the “indicated” yield, and pocket a nice profit of 5% for itself.

This worked against them also – because they didn’t try these stunts with g-secs, they tried it with illiquid corporate bonds, where they could easily do any pricing they wanted. And because of that, the early redemptions destroyed them. There was no market, and the yields had not gone down, and the sourcing banks must have been reluctant to buy back such bonds. (What the fund managers term “The AMC took the risk” – such bull)

Further there was the basic issue that they had bought bonds or pass through certificates with the eventual borrower being real-estate companies. These companies had no cash to pony up for an early call on the loan, especially when no other institution was willing to take it over. You might think they would default eventually anyway, but that is a situation we still have to see. So technically the AMC was left with no real money to pay redemptions.

The crisis therefore precipitated into a liquidity crisis – the AMCs having to beg RBI to give them some short term money; and while they’ve sorted things out currently – passing some instruments around, turning some FMP bonds into bank loans at the same or slightly different terms etc.

What now, that there are no early redemptions? AMCS will happily lend to (or buy bonds from) the same real estate companies, knowing there is no hope for redemption early. And since the return is “indicative” only – any lower return is borne entirely by the FMP investors. You can bet your right kidney that they will not give you any higher return, despite interest rates falling by 2% in the meantime. They will brand investors as stupid, and as unfaithful; no corporate treasurer will buy their products. So, as usual, the only one left to be screwed is Mr. Retail Investor.

And if they can’t buy longer maturity products they will invent “short term pass through” certificates that will provide the indicated yield, but be based on an underlying bond – effectively writing a call option for the person they buy it from. And the certificate will be a short term product.

This stuff stinks to high heaven and back. Someday it will be revealed as our little unknown scam.

Read Sucheta Dala’s “The Great FMP Scam” – it has much more detail.

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