Capital market regulator Securities and Exchange Board of India (Sebi) has extended the deadline for implementation of swing pricing mechanism in open-ended debt mutual fund schemes. It was to be implemented from March 1, 2022 but has been deferred to be implemented from May 1, 2022. Overnight funds and Gilt funds are exempted from this mechanism since these funds hold short-term liquid securities and government bonds, respectively.
The mechanism aims to protect small investors in debt funds against large redemptions from institutional investors at times of a crisis, like it was seen in 2019 and 2020.
"Swing pricing mechanism is an adjustment made to the published NAV during periods of extreme volatility. Take an example of IL&FS crisis, where the whole debt market had become risk averse and trading in NBFC papers were taking place at very high spreads. In such a situation, whenever a debt fund receives large redemption, in order to honor the redemptions, it may resort to selling quality liquid papers thus being a punitive action for the holders in the fund," said Vijay Kuppa, Co-Founder, Orowealth, a wealth and investment management fintech startup.
Debt mutual funds hold debt instruments like bonds, debentures and commercial papers, which are not as liquid as equity shares. So, if a large redemption order is placed, the debt funds have to either tap into their respective cash holdings or resort to selling the instruments they hold. This is where swing pricing helps.
“The reason swing pricing is important is that during redemption pressure, a mutual fund scheme is able to sell higher quality papers easily because that market is more liquid. For investors who stayed put, this means that they are stuck with a disproportionate amount of lower quality, illiquid paper. Swing pricing allows mutual funds to pass on the cost of these redemptions to the outgoing investors by lowering the NAV (net asset value),” says Kanika Agarrwal, co-founder of Upside AI, a portfolio management service provider.
Often, during market downturn and other special situations such as debt default by corporates, buyers of debt instruments demand a discount, especially in the secondary market, and the fund houses that are facing redemption pressure have no choice but to sell at a discounted price.
When India announced its nationwide lockdown due to increased Covid-19 virus transmission back in March 2020, the markets crashed. Bonds yields spiked (bond prices are inversely related to their yields), while the equity market had fallen heavily. As a result, mutual funds faced high redemption pressure from investors. To help tide over the crisis, the Reserve Bank of India (RBI) announced a special liquidity facility for debt mutual fund schemes to the tune of Rs50,000 crore from April 27, 2020 to May 11, 2020. Since debt mutual funds could not have sold the underlying instruments without taking a significant loss and they also had to honour all redemption orders, RBI’s liquidity scheme came to their rescue.
“While announcing the window, the RBI said the liquidity stress was limited to high-risk debt funds and came mainly after Franklin Templeton announced the closure of six debt schemes. The announcement from the RBI was a confidence-boosting measure that helped to reduce the yield volatility in the corporate debt market. This facility helped mutual funds that were facing large redemption pressure borrow at a lower cost (repo rate),” said Lovaii Navlakhi, founder and CEO, International Money Matters, a wealth management firm.
Swing pricing is a mechanism by which the cost of the traded security is adjusted with the net asset value (NAV) of a mutual fund scheme if the order redemption size crosses a specific threshold. Let’s take an example. Say, a fund ABC of Rs1,000 crore size has cash holding of Rs 50 crore. There is a market crash and some investors want to redeem units to the tune of Rs 400 crore. The ABC fund will have to either take a loan or sell underlying securities at a discount; otherwise it will not be able to honour the redemption order. This is where the swing mechanism comes in. For such a redemption, the trading cost incurred is deducted from the NAV of the specific selling unitholder so that the others who remain invested do not suffer from a lower NAV due to the high redemption action. So, in essence, there will be two NAVs--one is the reduced NAV for the selling unitholders and the other is for those who choose to stay invested in the said debt fund.
“Swing pricing is a mechanism by which mutual fund houses can adjust a scheme's NAV vis-a-vis the inflows and outflows of the fund under various market volatility scenarios. It is aimed at reducing the impact of large redemptions on existing unit-holders by reducing dilution of the value of a fund's units,” says Piyush Nagda, head-investments products at Prabhudas Lilladher, a financial services company.
As the bank deposit and returns from small savings schemes have been falling lately, many individual investors have parked their savings in debt funds. There are different kinds of debt funds; some of them take on higher risk to earn a higher return. “Investors moving a large amount from bank deposits to debt mutual funds that take on credit risk have witnessed multiple shocks over the past few years. In times of uncertainty, many people start redeeming their investments, either to move to a safe asset class or to fund their goals. High level of redemption could force liquidation at a discount. The ultimate impact is faced by investors by a way of fall in NAV. The swing measure can help mutual funds meet the redemption request without taking a haircut,” said Navlakhi.
How Will Swing Mechanism Help Investors?
India will follow a hybrid swing mechanism. This means that during normal conditions, a partial swing method will be used, and during special circumstances, a full swing mechanism will be used for high-risk open-ended debt schemes.
Swing pricing is already being practiced in the US, Hong Kong, France and the UK.
The swing mechanism that Sebi has proposed means you will not be able to freely redeem a large sum from a debt fund during a market crisis. The NAV for large transactions will be adjusted. “If the NAV of the fund is Rs100, the selling investor will only receive Rs99. This will apply to open-ended debt funds where even a 10 per cent redemption during market stress can be ruinous as these schemes hold high-risk debt compared to others and have higher costs of liquidation,” said Ajinkya Kulkarni, co-founder of Wint Wealth, a bond buying platform.
The lower NAV will help deter large investors from pulling out in a hurry and increasing the stress on a debt fund. “To help small investors, redemptions up to Rs 2 lakh for all unitholders and up to Rs 5 lakh for senior citizens will be exempt from this mechanism,” added Kulkarni.
