SEBI has acted, after JP Morgan’s fiasco after the Amtek bond problem – where it restricted redemptions for a while and then moved the “bad” bonds to a different scheme and only allowed investors to exit the “good” part of the scheme.
SEBI now has a new order for all Mutual Funds in such situations. The salient points:
This seals the deal for funds – they will not be able to hit investors with restrictions if there is a bad debt in their portfolio.
This also means something interesting. If there is a debt default and a fund holds a good portion of assets there, then you can redeem instantly since there is no possibility of restrictions if there is an issuer level default. And since everyone will try and redeem, the fund house is hosed – they will have to sell everything else in order to meet those redemptions. Most corporate debt securities are horribly illiquid, so finding buyers will be a mess. Since you have to find a buyer fast (you have to pay out in two days) you will sell those securities at a discount.
This discounting mechanism will hurt all NAVs of any other fund that holds these securities, so everyone gets hurts because of one debt default. Worst is the fund house – they will have to pay for the discount from their pocket, because they have to pay out as per the NAV of their scheme on the day of redemption (which didn’t include the discount!).
If this spirals, it will result in a liquidity situation for everyone – and then, it might even qualify as a “restriction event” when MFs can restrict further redemptions – but the damage would have been done.
And then, the poor fellows who didn’t exit because maybe they didn’t know, get hit the most – all that is left in the fund after this massive redemption situation is just the junk debt, and the NAV will crash.
SEBI’s move may sound investor friendly, but it does not help for a smooth transition when there is a default. You cannot just say “poor judgement” is a reason why a fund manager or house has to take the hit in such circumstances, because if fund managers are taking such a risk, then there is no appropriate compensation for it (fund houses get no percentage of profits, remember, they only get management fees).
The SEBI order may look good on paper, but in a crisis it will haunt the entire MF industry. In good times no one cares. In bad times, when there are defaults, suddenly everyone will. This will result in knee jerk reactions.
The bankruptcy act too allows for between 180 days and 270 days for resolution, and mutual funds do not offer risk-free investments. It would be better to consider more orderly resolutions for mutual funds too, when their investments go bad.