New SEBI guidelines on sectoral investment caps for funds could impact funding costs for HFCs and NBFCs adversely

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1 October 2012 ICRA RATING FEATURE OCT 2012 New SEBI guidelines on sectoral investment caps for funds could impact funding costs for HFCs and NBFCs adversely ICRA Rating Feature Contacts Karthik Srinivasan Vibha Batra Saket Kumar Nikhil Paranjape In the circular dated September 13, 2012, SEBI mandated Mutual Funds/Asset Management Companies (AMCs) to ensure that total exposure of debt schemes of mutual funds in a particular sector (excluding investments in Bank Certificate of Deposits (CDs), Collateralised Borrowing and Lending Obligation (CBLO), Government Securities, Treasury Bills and AAA rated securities issued by Public Financial Institutions (PFIs) and Public Sector Banks) shall not exceed 30% of the net assets of the scheme. It is also required that existing schemes shall comply with the aforementioned requirement within a period of one year from the date of issue of this circular, during which period, total exposure of existing debt schemes of mutual funds in a particular sector should not increase from the levels existing (if above 30%). The following note attempts to evaluate the impact of the new regulations on the various stake holders. Website 1

2 % schemes affected Analysis of Industry Debt Schemes suggests moderate redemptions of NBFC investments. Indian Mutual fund industry has been largely investing in Government securities and Financial sector entities (including banks) from their debt & money market schemes, thanks to greater availability of and liquidity in these papers. The strategy is also in line with the investor profile (largely institutional) in these schemes and accordingly the fund houses have to maintain liquid investments to meet any bulk redemption requests. At an industry level, investments in G- Secs and Financial sector account for over 66% 1 of the total Assets under Management (AUM) of the debt schemes. As can be seen from Figure 1, Bank CDs contributed 42% of total AUM of the debt schemes, followed by Corporate Debt (other than NBFCs) at 22% and NBFCs at 15%. While the cap is set at a high level of 30% of AUM, the guidelines can be viewed positively 2 as it seeks to reduce risks by ensuring a more diversified portfolio. At the same time, ICRA believes that the said new guidelines are likely to impact some of the income schemes of fund houses that have a higher proportion of investments in NBFCs while most money market funds will likely remain immune due to the higher levels of investments in G-Secs and Bank CDs; and the one year timeframe for compliance....however, select schemes are more affected due to higher exposure to NBFC sector As per regulatory classification, all financial services entities, including NBFCs and HFCs fall under single financial services/nbfc sector. ICRA estimates that around one-third of the total schemes would breach exceed the prudential 30% cap indicated by the said guidelines even if we exclude the AAA rated NBFCs that are also classified as PFIs. The Liquid schemes, on expected lines, are the least affected and >40% of Open Ended Income funds (including Ultra short term funds) will be impacted. Among closed ended income funds, the impact is lower with ~31% of the schemes breaching the sectoral cap as on August 2012 as most of the issuances are in the shorter tenures 3 which predominantly invest in Bank CDs. Consequently, most of the long term FMPs (~ 15% of the total FMP AUM of Rs 1.2 lakh crore) would be breaching the Figure 1: Deployment of Debt Funds August 2012 PSU Bonds / Debt 5% Corporate debt (other than NBFCs) 22% Other Money market instruments 2% G-sec, CBLO, T- bills 9% Source: SEBI Securitised Debt 0% revised norms set by the regulator. ICRA estimates each category that the (Aug 12) affected debt schemes (including the FMPs) in the industry which have cumulative assets under management of around Rs 1 lakh crore will have to pare around 15,000 crore of their NBFC investments to comply with the revised norms. Bank FD 5% NBFC 15% Bank CDs 42% Figure 2: Industry Data: Share of Schemes breaching sectoral cap 100% 80% 60% 40% 20% 0% 84% 16% Liquid Ultra short term Schemes impacted 59% 58% 41% 42% 69% 67% 31% 33% Other Open Closed ended ended income income Schemes not impacted Overall Source: ICRA Online, based on number of scheme in 1 Source: SEBI, Deployment of Debt Funds Monthly Report - August from MF investors perspective 3 Upto 400 days Initial maturity 2

3 ICRA rated debt schemes to witness limited impact ICRA rated debt mutual schemes are likely to witness a limited impact by these guidelines as the portfolio is reasonably diversified. Within the ICRA-rated universe of 94 open ended debt schemes, 43 are money market (Liquid & Ultra short term funds) and the remaining 51 are income schemes. ICRA ratings of MFs account for 58% of the industry AUM for open ended debt schemes as on June Based on analysis of ICRA-rated debt schemes as on June 2012, 3 of the money market schemes and 17 of the income schemes exceed the prudential 30% cap indicated by the said guidelines. In value terms, the AUM of the affected schemes accounts for 2% of money market and 30% of the income schemes. ICRA rated debt Total Number of Number of affected % AUM of affected MF schemes schemes schemes schemes Liquid funds % Ultra short term % funds Income funds % Overall % Source: ICRA Research Funding costs for NBFCs and HFCs could be adversely impacted Long Term FMPs have been a route for the NBFC sector to raise medium to long term funds at attractive rates from the bond markets. Consequent to current guidelines on sectoral cap, ICRA believes that the portfolio construct and consequently funding to the NBFCs would witness a moderate impact. The funding pressures would get accentuated if the existing FMPs with maturity beyond September 2013 (largely passively managed funds) too have to realign their portfolio within the stipulated time to meet the revised sectoral investment norms. Accentuated by these concerns, we are witnessing widening of spreads for select NBFCs and HFCs over the past few days. Anecdotal evidence suggests that for top rated NBFCs (including HFCs), the normalised spreads over corporate bonds/bank CDs of similar tenures had widened by bps for the period September 13, 2012 to September 27, Moreover, slightly long tenure CP issuance (9 months and above maturity papers) of other NBFCs at lower rating levels have not been able to evince investors interest over the last few days, with the Mutual Funds actively realigning their portfolio pursuant to the said SEBI circular. Given that SEBI has given a period of one year to comply with the prudential norm on exposure cap, the extent of reconstitution of portfolios would depend on the maturity profile of the underlying instruments. Hence, a scheme that is breaching the exposure cap as on date might not require any reconstitution if the maturity profile is such that it meets the norm after one year. Nevertheless, the schemes requiring reconstitution could face challenge in terms of availability of corporate debt papers. Consequently, with the expectation of moderation in interest rates over the next months, yields on corporate debt could decline to a greater extent as compared to that of NBFCs. Further, it remains to be seen if fund managers increase exposure to comparatively low rated papers in order to give better returns to the investors. Going forward, the fund houses will have to balance the returns and credit quality of the underlying instruments. Further, SEBI guideline on mark-to-market (MTM) on papers with residual maturity of over 60 days (from earlier 90 days) with effect from October 1, 2012 is likely to result in increased ALM/rollover risk for issuers as most fund houses may prefer in investing in less than 60 day CPs. Our discussions with debt MF fund managers suggest that the recent CP/CD issuances have been at 60 day tenor and are likely to continue going forward. 3

4 In addition, mutual funds have off late been staying away from investments in securitized debt (namely Pass through Certificates) due to the uncertainties relating to the taxation of Pass through Certificates. Most of the originators of securitized debt in the Indian market are NBFCs. However as credit enhancements are normally provided by the NBFCs for their transactions initiated by them, there could be some ambiguity on the sectoral classification of these securities. ICRA believes that if the exposure to securitized debt is not taken as a NBFC exposure and further there is a favourable ruling on the tax related issues, mutual funds appetite for such investments would increase thereby partly alleviating funding pressures for the NBFC sector. However, till then the above new guidelines could have material impact on some of the NBFCs that have a higher dependence on mutual funds and those that carry relatively higher levels of asset liability mismatches. We also believe that NBFCs engaged in capital market financing activities and other segments that are not eligible for bank funding could see moderation in business levels. Accordingly NBFCs reliance on banking credit will go up further. However, any regulatory tightening on that front may push the NBFCs to adopt a more expensive public issue route (the quantum of which is relatively low) or slow down the credit growth. Thus it will be important for these entities to have adequate backup bank lines and maintaining liquidity buffers at all time, thereby increasing the overall cost of borrowing for the NBFCs. October

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