Bond markets: issues and implications

This post collates some of the issues being highlighted by experts regarding the Indian corporate bond markets, and the implications for debt mutual funds.

Debt funds are risky…

Suyash Choudhary, head of fixed interest at IDFC AMC, outlines the market structure and issues –

  1. The macro
  2. Markets for financing in India
  3. Behavioural thinking and operating in a data vacuum
  4. First principles on mutual funds
  5. Value chain in the mutual fund business

Key insights from this session – India has a data vacuum in the macro indicators which has implications for the fixed interest markets. Indian debt mutual funds have been buying illiquid and higher credit risk bonds while the disributors and investors have only been looking at past performance. Risk is being measured only by volatility rather than by look-through credit risk. Credit funds should be seen as ‘satellite’ products when constructing portfolios.

Choudhary also makes the point that rating agency and distributor/adviser intermediaries need to do better product research.

Bonds are not being valued properly

Anubhav Srivastava, fund manager at Infinity Alternatives, digs deeper on the valuation issues in the credit bonds market and its implications.

Srivastava points out that fund managers in India have discretion among various options – mark-to-market, mark-to-matrix and mark-to-valuation. This choice can lead to perverse outcomes including corruption.

Another senior executive with experience in mutual funds operations agreed that such discretion exists. He pointed out that there are multiple stakeholders within a mutual fund when it comes to bond valuations such as unit pricing, compliance, risk management and the fixed interest investment team. In theory, the unit pricing team should function independently, but in practice, the investment team dominates.

As background, debt funds follow a waterfall-method to bond valuation in line with SEBI circulars, which in turn was based on the 2016 report by Working Group on Corporate Bonds and public feedback.

The waterfall-methodology follows Security Level Valuation (SLV) of securities between step 1 till step 5. Thus, if a security cannot be valued from the method as described at first step, the valuer needs to go down the waterfall. These steps involve using trade data for the purpose of valuation and polling is not permitted at any of these steps. Further, in case where valuing a security is not possible in terms of step 1 to 5, step 6 is proposed which requires construction of a spread matrix, which, inter-alia, involves polling from the market participants. The waterfall mechanism proposed is as under:

  1. Trade in the security (Same ISIN)- Same day trade
  2. Secondary trade of security of same issuer with similar maturity
  3. Primary issuance of same issuer similar maturity
  4. Secondary trade of security of similar issuer with similar maturity
  5. Primary issuance of similar issuer with similar maturity
  6. Matrix Construction

Srivastava points out that bond ETFs reflect the market’s view on underlying bonds, hence are a good barometer.

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