Let me ask a basic question. Can a mutual fund invest in a bank fixed deposit?

What about a fixed deposit in say Tata Steel?

No. Basics of mutual fund investing is that  a mutual fund should invest only in “marketable securities”. Marketable securities means something which can be sold in the market without recourse to the issuing company. So if Tata Motors issues a bond -worth say Rs. 10,000 crores and this is a public issue, mutual funds can buy it from the market. WHICH means if they want to sell it, it can be sold in the market.

He he he….this is theory.

Now to create a facade of being “marketable” – fixed deposits are called “privately placed bonds”. None of these bonds have a market value…well that is what happens when the market implodes. On a much bigger scale this is what happened in LTCM. Let us say the above mentioned TaMo bonds are bought by 200,000 people with varying needs, the chances are it will be traded regularly, and there will be a secondary market for this. This market could be created artificially or it could develop on its own.

However if a promoter converts his holding to a bond, and then says these are “marketable” – you KNOW it is a lie. The only hope is a perennial renewal at the current rates. This is more like a FLOATING rate bond that zee issued and were all bought by a few mutual funds who had no reason to seek liquidity (from the fund point of view)..

Does the regulator not know that these securities run liquidity risk?

Did the fund manager not know that one should not take concentration risk on a product with liquidity risk?

Did the trustee ever EVEN ask the fund manager about putting the portfolio through a stress test?

The ‘trustee’ role and ‘owner’ role is what gets my goat. I am not convinced that the risk committees of Hdfc bank and K bank would have allowed such a loan to be given. I am not sure that they would not have got their ‘security’ enhanced. K securities does trading against margin, would they have sat tight when a default was happening? would they have accepted such a big ‘block’ of securities? Do K and H securities not know the risk of ‘illiquidity’? I remember one transaction in 2001 being rejected by H saying “liquidity does not exist”. That bugs me.

An instrument rated as A is not a fraud. It is clear that it is a single A and is not the same as having a Tata Sons AAA bond which may not even carry any securities with it. However even a Tata Sons private debenture maybe liquid ONLY by going back to the issuer – this violates the law on grounds of “principle” – and risk your principal.

Does the FMP Offer document talk about delay in payment? about investing in a fund that may have credit risk?

Well partly yes and partly no.

It says “will invest in instruments which mature before….”. Well did the FM not violate this by allowing the roll over?

well, this was extraordinary circumstances, so he/she had to take this call – FAIR ENOUGH. Knowing that an instrument rated A can default is very basic.

Personally I do think that if the underlying asset for an instrument is equity, you bring equity risk to a bond fund. This is a little worrying, but I am sure it will be “everybody does it”.

LOOK at this extract from the offer document..

Risk profile of the scheme

Mutual Fund Units involve investment risk including the possible loss of principal. Please read the SID carefully for details on risk factors before investment. 

The question is was this ever communicated to the investor? well, the amc did it by putting it in the OD. Did the distributor convey this? very very unlikely. Not that it was unintentional, he may not have even known about it.

Most fund managers did invest in ILFS – and they did not even seek any security. We have no clue how that shit is going to be solved.

In an equity fund people realize that the portfolio can go up or go down. In debt people forget that the same conditions apply.

The regulators biggest mistake is that they have not developed a secondary market for debt instruments. If there is no “Price discovered markets” – we will be guessing about the security.

Will you invest in LnT based on the PE ratio of say Tata Steel? Sounds ridiculous, right, but in the bond market I have to find out “what coupon did…..” so that I can price my LnT debenture. Sounds odd?

This is the 26th anniversary of Mr. Patil saying “we will develop a robust retail and wholesale debt market soon”.

Well, I will be around for 50th anniversary too. I hope.

For a more detailed analysis read posts by Deepak Shenoy amd Mfcritic.blogpost.

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  1. Seriously does SEBI or MF Trustees have enough manpower to scrutinize every investments that MFs make? I don’t think so. This is similar to Rating agencies not knowing what underlying securities they are rating as AAA. I mean the sheer amount of transactions, bonds, funds does not allow any pro-active scrutiny by regulators or anyone else. It is total myth that regulator and trustee keep a tab on everything. Also if one fund house does something, then its an exception and if everyone does it its a normal.
    The only way things get found out is by whistleblowing which happens after the fraud is committed.
    And then everyday the world has a new problem on its hand, so yesterdays ILFS issue is no more hot topic today, similarly Zee problem today will die down tomorrow whether money comes back or not.
    But Zee stocks will survive, Subhash Chandra will get another 20000 crore from MFs next year and life goes on.

  2. Well again trustees checking stress on assets is reactive. But what you mentioned in the above article is whether they buy marketable securities which is pro-active risk management. Now i dont know how frequently they meet, but do they sit around and do pro-active risk management for every fund they float i am not sure. Fund houses have 1000s of funds and lakhs of securities, so the system runs assuming everything will be alright in the end. But it only leads to catastrophe lile these

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