A recent change in SEBI rules will hit the debt fund market soon. The rule says just one thing: That funds will reduce amortization on bonds to only those that have 30 days or less remaining to maturity.
I will wait till you clean up after you’ve spit out your coffee because that sounds totally like gibberish, and you’ll ask: Abeyaar, explain in English.
The point is to look at mutual funds, the liquid fellows. Why do people love them so much? Because they have a feature in which you can park money with them for the very short term. Like one day also.
How? Well, they buy stuff called “paper” – meaning, bonds or commercial paper or the like. Which are where companies borrow money. Give me X money and here, take this “paper” which says I’ll give you back (X+n) percent interest.
Very nice, you say. Because you can now sell this paper to me, and the company will give me, instead of you, the (X+n) percent interest, because I have the paper.
There is no paper though. Just to be sure you understand. Because nowadays people believe everything they read. There used to be actual paper. Once upon a time. But you don’t like that phrase. So let’s just say there’s a big large computer in the sky that has all the information and when you sell to me, that computer knows. Don’t ask me how, but it knows. So when the company has to pay back, it just has to ask the computer who currently has how much paper and pay them back.
So let’s say there was this company called Reliance. And it said it wants me to give it money at, say 8 percent a year. I’m happy to give money, because if Reliance doesn’t pay back I’ll have 100 years free service from Jio at least. Just kidding. (99 years is enough)
But how do I give it? I can do this: Dear Reliance, here’s Rs 100, pay me back Rs 102 in three months. That’s Rs 2 interest, which is 2 percent for three months, which is 8 percent a year.
That’s one way. Another way is to say: here, take Rs 98.04. Give me back Rs 100 in three months. Same thing, but you give me back a round number always (Rs 100) no matter what interest rate you use, just so we’re being nice.
The first kind is used in regular “coupon” bonds. The second kind is used in “zero coupon” bonds. In the first case, the principal given is Rs 100 on which you get Rs 2 interest. In the second, the principal is Rs 100, but you give it at a discount, and the principal is returned – effectively the discount is the interest.
The Selling Price
Now consider that I want to sell this paper. I gave you something at Rs 100 for 90 days to get back Rs 102. After 10 days, what is it worth?
If you believe that the same 8 percent is what anyone else would be willing to lend to Reliance at, then you have to consider that only 80 days are left (to maturity). So by the complicated formula:
Price = 102 / (1 + 8%*80/365)
Price = 100.24
Which means this: The paper you paid Rs 100 for, is now worth Rs 100.24 after 10 days.
Why? Because someone was willing to lend to Reliance at 8 percent when you wanted to sell.
a) If someone was only willing to lend to Reliance at 9 percent, price would be: Rs 100.02 (it’s not gained as much)
b) If someone wanted 10 percent, the price would be Rs 99.81 (you would be losing money so far!)
c) If someone loved Reliance (maybe he wants many more Jio connections) and was happy to lend to them at 7 percent, the price would be Rs 100.46 (your gains would be much more)
So, the market price of a bond is about how much a buyer is willing to pay.
Why would buyers pay more? Or less?
Say the RBI suddenly decided to cut rates massively in the market. What is attractive at 8 percent today (because it’s higher than RBI rates of 6.25 percent) may be attractive at 7 percent (if RBI’s rate falls to 5.25 percent). So the market may take a lower “yield” because interest rates have fallen across the board. Let’s call this interest rate risk.
What if suddenly the government cancel’s Reliance’s telecom licence? Then suddenly no one wants to lend to Reliance because we can’t even get free Jio connections if they don’t pay. (Listen, I’m kidding about the Jio connections, but you’re smart enough to know that, I know!)
Then, the fear that Reliance cannot pay will take over, and people will demand 10 percent, 12 percent even 15 percent for them to buy from you. Prices will change also according to credit risk expectations, meaning if they believe there’s a higher or lower risk of your paying back on time.
There’s other factors – liquidity risk is when you’re the only buyer in town and therefore I have to take your price even if I think it’s worth more, because I have to sell today. There’s also things like I’m happy to give you 8 percent for 90 days but if you want five years I’ll only do 12 percent. Lots of factors, but one thing it shows in is: Price.
The traded prices of these bonds fluctuate according to what other people will trade at.
How do liquid funds figure in it?
Liquid funds buy the really short term paper. Stuff that’s maturing in less than 90 days. So they are the folks that lend to companies like Reliance, or the government, or an institution like NABARD, but they typically have paper that matures within 90 days from when they buy it.
The NAV of a liquid fund should be the market value of each bond that it holds. The market value should be the last traded price multiplied by the bonds it holds. The market price, as we have seen, fluctuates because of various factors.
But this creates a pesky problem.
Remember I told you some people loved to park money in liquid funds, sometimes overnight?
These people – actually these are people who are businesses – want interest. Because no bank will give them a fixed deposit for one day. Their current accounts yield nothing. But they also need money to be in their bank account to make payments etc. as required. So every day, they pay the people they have to pay, and then put the rest in a liquid fund.
And then the liquid fund is “redeemed” the next day. And they make more payments and park the remaining back in, etc.
The one thing they assume is – they will not lose money. They should always see more in the redemption than they put in. Otherwise what’s the point?
But if you have prices fluctuating like I demonstrated earlier, the NAV of the liquid fund will rise or fall. Rise is okay. Fall is bad! Because if it falls even for one day, then the overnight “park” of money will see people lose money. And such people have alternatives – to not park money at all!
So liquid funds have this magic wand: Amortization.
What is Amortization?
Now Reliance is quite unlikely to default. At least not in the next 90 days. So it’s quite likely that even if the market price falls, that you will get your Rs 102 at the maturity date. So then is it ok to “ignore” the market price and instead use a different mechanism instead?
What if you said – I bought at Rs 100, I’m going to get 102 in 90 days. That’s equivalent to Rs 0.022 per day. So instead of considering the market price I’ll just increase my buy price by Rs 0.022 per day. So if the price today is Rs 100 (when I bought) , then the price tomorrow is Rs 100.022 and the price the day after tomorrow is Rs 100.044 and so on.
This is good if Reliance doesn’t default, of course. And it’s also good if I can hold the bond till maturity (i.e. I don’t have to sell before that) And the process is basically that prices increase in a straight line. We just ignore the madness of the markets in the interim.
This is great for the overnight “parkers” – who always get to see an increase in their value. There are others who park money for longer periods – say a week at a time – and even for them, the price rise is linear.
But there’s a risk. What if too many people withdraw? Then the fund has to sell at the market price. And that creates a problem – as the market price may be much much lower!
And also, what if a company can’t pay back? Or is massively downgraded 60 days before a bond matures? Then it’s not right to continue to amortize because the risk of not getting paid back is huge.
What to do? This was not usually a risk – if a company couldn’t pay back, it would just rollover the loan (issue new paper and use that money to pay back maturing paper). But in a time when a company is downgraded, there are no buyers for the rolled over paper – and boom, the company has to default on the maturing paper.
This is a systemic risk – as in, if amortization is continually allowed, then we could be seeing major deviations from reality.
Especially because mutual fund managers are paid for keeping money with them. When you mark to actual market price, there will be fluctuations. Fluctuations means companies won’t park money overnight. No money means the fund manager makes less money. And no one wants to make less money.
For the liquid fund: Fluctuations are not desirable – by the investor, and therefore by the fund manager. But amortization has systemic risk in that it deviates from reality.
SEBI rules: Gradually bring down amortizable limits
Earlier SEBI would allow amortization up to 90 days. Means if you have 90 days left, forget market price and just amortize the remaining. Then there were exceptions – like if YOU sold part of your holding at a lower price, take the lower price, don’t amortize. But if someone else sold theirs at a lower price, you could ignore it. If another fund manager at your company sold at a lower price then complicated things happen, which we won’t get into.
The impact: Companies would issue 90 day paper mostly. Mutual funds would love it because no fluctuations because amortization. Companies would then reissue the paper after 90 days, effectively rolling over the loan. (This is okay for businesses that have regular cash requirements but also see cash going in and out. Just don’t finance long term loans with them.)
But a little while ago in 2012, SEBI brought down the “amortization” limit to 60 days. What happened?
Companies started to move to the 60 day mark – because hey, at 90 days, mutual funds have to mark to market. Which can be a problem, and mutual funds will lose their AUM. So the liquid funds forced companies to issue at 60 days instead.
See Siva’s tweet thread on this.
This meant companies would rollover every 60 days instead – with 6 issuances a year, instead of the earlier 4. (Once every two months versus once every four months). Any such rollover has a cost – the new stamp duty says 0.01 percent at the minimum. Six rollovers cost 0.06 percent at least – plus brokerage and others.
The change: Let’s go to 30 days instead
SEBI has now said that amortization will only be allowed for upto 30 days to maturity. Meaning 60 is down to 30.
This is to avoid systemic issues, surely, but it created problems:
– Liquid funds will want to now buy only at <30 days to maturity
– Companies will have to issue at 30 days max (or push towards that time frame)
– Liquid funds have massive AUM (nearly Rs 5 lakh crore in Feb 2019) and see massive turnover (Rs 18 lakh crore bought and sold in Feb 2019 alone) so they can dictate terms
– Companies now have to do 12 rollovers (max 1 month to maturity means 12 times a year) instead of six earlier
– If each rollover costs 0.01 percent stamp duty, that’s 0.12 percent right there as costs. Higher when you consider brokerage and fees.
You might say: but why should a company rollover so many times? Say Reliance is getting paid a massive Rs 500 crore. for an order of petrol they have dispatched today, but the money will come after five months. They can sell commercial paper for five months maturity, and use the money today, and when they get paid, pay back the commercial paper.
But liquid funds won’t buy the paper. It’s five months to maturity. That bad word: fluctuation. If liquid funds don’t participate, Reliance has to find new buyers who will demand higher interest rates.
So Reliance does what the market will want – 30 days at a time, rolled over five times. Increases their cost, that’s all.
The End-Game for Amortization
In an ideal world, you shouldn’t have to amortize. The prices will all be reflective of reality, there will always be a rational buyer at a rational price if you want to sell. In an ideal world corporates will not rollover their liquid fund investments every day either – they will know how much money they need, and they will only withdraw that much, leaving enough back in the liquid fund.
We will now sprinkle water on your face.
In the real world, there are imperfections, and the amortization concept was brought about as a mechanism to reduce investor “fear” of volatility. But once we were aware of the side effects, SEBI brought amortization limits from the 90 day paper to 60 day and now 30 day.
The message is: embrace the real price. Expose investors to volatility because that’s how the world is.
Even if the market price fell on one day because someone sold at a low price, it will recover very fast because you are very likely to get paid back. Btw, this applies for government bonds too where there is near-zero risk of default – even there, if someone sold in the market at a ludicrously low price, it will impact everyone else who holds it, even if they don’t want to sell it.
You could of course now see abuse. If one fund has loaded up on one paper that matures, say, in 35 days, another fund can buy it and dump a very small quantity at a very low price. Given it’s illiquid, another trade may not happen, and boom, that low price becomes the “mark” of the day – hurting the first fund. Answer to this: Diversify.
(This abuse happens in the both directions usually. Funds wink, wink and nod, nod and sell small quantities of bonds at a higher or lower price, just so that they can increase or decrease the NAV appropriately. And because SEBI is aware, now funds have to give trade level disclosures in debt. Such fun. But that’s for another day.)
There’s short term consequences too: higher costs. Like Siva says:
Who benefits from the regulatory change to 30day amortisation? Hard to tell. Who loses? Investors in liquid funds (lower yield, more turnover and txn cost) and corporates (more txn cost, more risk). (8/6)
— Sivakumar (@eyeofsiva) March 1, 2019
Since the point of this whole thing was to make this simple for you, let me say this:
– If you have invested in liquid funds, you might see returns fall a little. But it’s unlikely to matter to most retail investors. Still a great place to park short-term money.
– If you are a corporate looking for overnight parking of money, you might want more technology to help with cash management to park money for longer periods than one day. (And there are overnight funds for that one day thing specifically)
– If you’re a corporate issuing commercial paper, you’ll have to consider if the cost is worth it (moving to 30 day paper instead of 60). But considering most bank loans for good corporates are still above 8.5 percent, you might be better off with the commercial paper market – even at marginally higher rates.
– If you are a reader of this site who suddenly feels attracted towards buying liquid funds, please note that we fully encourage you to consider keeping money there – they seem to return more than fixed deposits nowadays.