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Fixed Income

That Shady Mutual Fund Inter-Scheme Transfer Gets Whacked By SEBI

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SEBI has in a circular told mutual funds about how they can no longer do “Inter-scheme” transfers of bonds. An inter-scheme transfer is when they move a bond from one scheme to another, without actually trading it in a market.

Why would mutual funds do this? Well, assume you have a 12 month corporate bond, and it’s sitting in an low duration bond fund. You’ve now held it for 9 months, and there’s just 3 months left to maturity. Keeping it on the low-duration fund will reduce the “duration” of the fund, so they have to sell it. But it’s a pain to sell it, and in any case, you have a liquid fund. That liquid fund needs to buy things that are less than 3 months to maturity. So you do an inter-scheme transfer, where the liquid fund buys the 3 month bond, and pays the low-duration fund the money. The LD fund will then go buy something else from the market or such.

In other cases, a fund may breach a sector, issuer or group limit by certain bonds going up too much. They can do an inter-scheme transfer to balance this out.

However, this has been misused. Where? We had in our debt masterclass (link here) demonstrated how HDFC Mutual Fund had moved a bond of “Gera Developments” from a credit risk fund to a Fixed Maturity Plan (FMP). In fact,  transferring corporate bonds internally to an FMP is very dangerous. In an FMP, investors pay up for a certain time frame and know within a few days what kind of portfolio is being constructed. They can’t exit until the final closing date of the FMP. For such investors, to suddenly see a fund manager buy corporate bonds that they didn’t expect, can be a negative surprise.

HDFC Mutual Fund was facing large redemptions in their credit risk fund (their AUM halved after the Franklin fiasco). The need for redemptions might have pushed them to transfer these bonds to FMPs, and then the FMPs would give them cash for redemptions.

It’s not just a problem to dump bonds on to FMPs. Sometimes they move bonds to other schemes. TheMFGuy has a post on how, after those massive credit risk fund redemptions, AMCs chose to move bonds to other schemes – Hybrid schemes, balanced schemes and so on. Again, this can be a dangerous thing.

What’s SEBI Saying?

First, Mutual Funds can no longer transfer to (or from) FMPs. Exception: the first three days after buying.

Second, in other schemes, SEBI knows there could be liquidity needs. Meaning: redemptions that need cash to be paid. So in that case:

  • The scheme has to pay from it’s cash
  • The scheme should borrow to pay money (there are limits, but I suppose they mean such limits should be exhausted)
  • They have to attempt to sell those securities first
  • And only then, they can do an inter-scheme transfer to raise cash.

Third, fund managers should be penalized, if they transfer a bond from a credit risk fund to another scheme, and then the bond defaults within a year.

Fourth, if there’s negative news about a company, even “rumors”, then an inter-scheme transfer isn’t allowed.

Fifth, duration/group/sector limits is a valid reason to do an inter-scheme transfer.

Finally, everyone and his uncle (read: trustees) must be given a detailed justification in case a bond defaults after an inter-scheme transfer.

But strangely, this is only applicable after Jan 1, 2021. Which means they can keep doing this for another three months or so.

This is a good thing.

While fund managers should have flexibility, there has been a layer of discomfort in debt fund inter-scheme transfers. The price is not the problem – even inter-scheme transfers have be to based on pricing given by a valuation agency or committee. But the basic point is whether you can transfer the risk from one fund to another, internally, whenever you see fit. Especially when there’s no one else likely to buy your security in the market.

Unfortunately, a few mutual funds have effectively become bankers. They are sometimes the only lender to a company. Those bonds are not in demand anywhere else, and the fund houses use inter-scheme transfers to move things around. My own analysis of trades show how funds are moving bonds between two FMPs that have similar maturity dates (why?) and that seems totally unnecessary. When you hear of such situations, and the trustees don’t play a strong role in questioning this, SEBI will act. However, we have to see if anyone gets fined for violating such rules: There are too many rules, and sometimes, too little enforcement.