Last week’s abrupt and unprecedented announcement from Franklin Templeton India to close its six yield-oriented, managed credit funds has dented the confidence of investors in mutual funds.

While the fund house as well as MFs industry body Association of Mutual Funds in India (AMFI) tried to downplay the event, the problem is industry-wide and can take shape of a contagion.

Taking note of the problems, the Reserve Bank of India (RBI), on Monday, April 27, has swing into action with an announcement of a ₹50,000 crore special liquidity facility for MFs. “Heightened volatility in capital markets in reaction to Covid-19 has imposed liquidity strains on mutual funds, which have intensified in the wake of redemption pressures related to closure of some debt MFs and potential contagious effects therefrom,” the RBI said in a release announcing the measure. “The stress is, however, confined to the high-risk debt MF segment at this stage; the larger industry remains liquid,” RBI added to calm nerves.

In a flash reaction note on RBI’s Monday morning move, banking and financial services’ analysts at Mumbai-based Prabhudas Lilladher wrote: “Although coming tad late, such near term liquidity for MFs will aid tackling redemption pressures and further help soothe corporate bond market.” However, individual exposures to credit papers will decide the final outcome, the note added.

There is merit in the claim that the measures came late. In an April 26 note, Mahesh Nandurkar and Abhinav Sinha, both equity analysts at Jefferies India, highlighted that MF debt funds have been under pressure for some time now. The duo explained that debt MFs (bond + liquid) had assets under management (AUM) of nearly ₹11.8 lakh crore as of March 2020, which was almost flat when compared to March 2018.

Within that, bond fund AUM, which includes government securities (G-Secs) as well, declined 11% to ₹7.1 lakh crore. And, higher yielding credit-risk funds saw their AUM shrink by 30% over FY20 to end the year at ₹55,000 crore. “Risk aversion has manifested in debt MFs since the NBFC (non-banking finance company) liquidity crisis of mid-2018,” Nandurkar and Sinha noted. “The issue of 'segregated units' (defaulted paper) caused further investor sentiment damage to these fund earlier in FY20 with regard to paper of stressed corporates such as Essel group, Vodafone-Idea and DHFL.”

Nandurkar and Sinha further added that there is strong risk aversion in debt mutual funds in recent times. And, the credit risk-off has been reinforced by the announcement of windup of the six credit-risk MF schemes. “Heavy redemptions from the credit/corporate bond fund over last few weeks and the illiquid corporate bond market led to this extreme step,” the duo noted. “This combined flight to safety, both by banks with liquidity and potentially by the retails investors, at the same time, could create a vicious cycle for the smaller NBFCs and in-turn, corporate borrowers with A and below ratings.”

However, in its announcement of ₹50,000 crore special liquidity facility for mutual funds (SLF-MF), RBI reiterated that it “has stated that it remains vigilant and will take whatever steps are necessary to mitigate the economic impact of Covid-19 and preserve financial stability”.

Explaining the mechanics of the on-tap and open-ended SLF-MF, RBI told that it would conduct repo operations of 90 days tenor at the fixed repo rate which shall be available from April 27 till May 11, or up to utilisation of the allocated amount, whichever is earlier. “The Reserve Bank will review the timeline and amount, depending upon market conditions,” the central bank added.

The funds availed by the banks under the SLF-MF shall be used exclusively for meeting the liquidity requirements of MFs either by extending loans, or undertaking outright purchase of and/or repos against the collateral of investment grade corporate bonds, commercial papers (CPs), debentures and certificates of Deposit (CDs) held by MFs.

RBI clarified that the banks from whom the SLF-MF liquidity support is availed, would be eligible to classify the same as held-to-maturity (HTM) even in excess of 25% of total investment permitted to be included in the HTM portfolio. Also, exposures under this facility will not be reckoned under the Large Exposure Framework (LEF).

And, the face value of securities acquired under the SLF-MF and kept in the HTM category will not be reckoned for computation of adjusted non-food bank credit (ANBC) for the purpose of determining priority sector targets/sub-targets. “Support extended to MFs under the SLF-MF shall be exempted from banks’ capital market exposure limits,” RBI added.

According to Joseph Thomas, head of research at Emkay Wealth Management, who calls the RBI measures as "timely and extremely laudable", highlights that the closure of the six schemes has resulted in eroding the confidence of investors to a large extent. “This usually results in more redemptions and may lead to liquidity problems for the mutual fund industry, when many of them already have negative cash in debt funds,” says Thomas. “So, more than a crisis of liquidity, it is a crisis of confidence.”

The RBI’s SLF-MF, in Thomas’ view, will serve to alleviate the fears in the minds of investors and also dissuade many from getting into the redemption mode. “Even then, the after-effects of the low-rated credit risk fund portfolios may haunt the mutual funds for some more time to come because of the economic slowdown and the resultant sluggishness in economic activity emanating from the pandemic.”

Follow us on Facebook, Twitter & YouTube to never miss an update from Fortune India. To buy a copy, visit Amazon.