What Is CDMDF And How Can It Make Debt-Funds Safer Investments?

For years, debt funds have been touted as safe investments for investors. These funds invest in debt securities like bonds and debentures issued by companies and governments, and help conservative investors earn relatively steady returns.

However, illiquidity has been an issue faced by these funds for years.

India’s debt markets are still developing and lack liquidity, especially in the corporate debt security segment.

Consequently, when liquidity dries up during periods of crisis, high redemptions (debt fund investors selling their holdings) combined with illiquid markets result in a crisis for these debt funds.

Recently, something similar happened at Franklin Templeton Mutual Fund (FT) in 2020, when the pandemic began. Redemption requests flowed in at an alarming pace, while liquidity in the bond markets dried up.

FT chose to “wind-up” the funds, meaning that customers wouldn’t receive cash immediately, but would have to wait for some time to get their money back.

This was done since selling Rs 25,000 crore of debt securities into an illiquid market would have high impact costs and investor returns would be much lower. However, this isn’t the first time debt funds have faced such an issue.

Even back in 2008, several large mutual fund houses faced similar issues in their debt funds.

Several funds limited their redemptions to five per cent of the fund size, and put in additional limits of Rs 1 lakh per investor per day. Similarly, in 2013, when India’s economy was plagued by high inflation and low investor confidence, mutual funds faced a similar crisis.

While such instances do not occur regularly, the lack of liquidity in periods of crisis can have more severe ripple effects on the market and investor confidence.

Hence, each time, a severe liquidity crisis struck, Reserve Bank of India opened a special liquidity window for mutual funds to sell their investment grade securities.

SEBI has now come up with Corporate Debt Market Development Fund (CDMDF) to help mutual funds tide over liquidity troubles.

The CDMDF was inaugurated by Union Minister of Finance Nirmala Sitharaman on Friday (28 July). The CDMDF would be structured as a fund itself, with Asset Management Companies’ (AMCs) debt funds contributing 0.25 per cent of their assets under management to the fund.

In addition, they are expected to make a one-time contribution to the fund as well.

For these funds, these contributions can be seen as a premium paid for the bail-out they would receive in a time of crisis. The initial fund size would be Rs 3,000 crore, and the fund can take on debt that is ten times more than its size, taking the size of the bailout fund to Rs 33,000 crore.

In case the fund needs to take on leverage, it would be funded by lending institutions without trouble, since the loans are guaranteed by the government itself.

The CDMDF will not pay the entire amount upfront to mutual funds, but rather, will pay 90 per cent of the amount in cash to the funds. The balance 10 per cent will be transferred to mutual funds in the form of units of the scheme.

In the past, AMCs’ debt fund investments have gone awry due to investments in risky securities in their search for a higher yield.

Since the fund managers are now assured of having a backstop in place, it could increase the occurrence of fund managers buying high-risk debt securities and then selling them off to the fund during time of crisis.

In addition, liquidity crisis are more pronounced in securities of companies with high credit risk. In order to prevent such activity, the CDMDF will only buy investment grade securities i.e. debt securities with high credit ratings.

In addition, in case of a default on a debt security that a mutual fund sold to the CDMDF, the 10 per cent units that the mutual fund had earned on the sale will bear the first loss.

These mechanisms are put in place to prevent funds from using the CDMDF as a bailout instrument.

The CDMDF is expected to increase investor confidence, especially since debt mutual funds are used by institutions whose redemptions can run into thousands of crores.

With the launch of the fund, mutual funds wouldn’t have to rely only on the Reserve Bank’s intervention for liquidity.