Last week, SEBI introduced a new swing pricing framework for debt mutual funds to protect retail investors in times of massive redemptions.
What is it?
Under swing pricing, an AMC adjusts or ‘swings’ by a certain percentage the net asset value (NAV) of any MF scheme facing redemption pressure. Once swing pricing is enforced, all investors exiting or entering the scheme can transact only at the adjusted NAV — which is lower than the usual NAV.
The purpose of swing pricing is to pass on the cost of redemptions — in the form of a lower NAV — to those selling their scheme units. Incoming investors who are countering the outflow, benefit from a lower entry NAV.
Open-end mutual funds, which promise to allow investors to cash out their units on demand usually have systems in place to ensure they can smoothly handle small and phased-out redemptions. In normal times, an AMC can meet redemption requests. However, when there are bunched-up redemptions and the fund too is unable to liquidate its holdings to meet them, then the fund may be forced to resort to distress sales of its holdings.
The most obvious costs — trading costs, the price impact of executing large trades and cost of borrowing to meet redemptions — all eat into scheme returns. Better quality and more liquid securities tend to get sold first, leaving investors who have stayed with the scheme with lower returns and a poorer quality portfolio. Swing pricing attempts to resolve this inequity.
Under SEBI regulations, swing pricing will be implemented only in case of net outflows (outflows exceeding inflows) from a debt MF scheme. Under the framework which will be enforced from March 2022 there will be partial and full swing. In normal times, an AMC can implement partial swing — that is, introduce an adjusted NAV for entering/exiting investors once the net outflows from any scheme cross a certain threshold.
In extreme market situations, SEBI can declare that markets are dislocated and full swing pricing can be enforced on all high-risk open-ended debt schemes for a specified period.
To safeguard small investors, redemptions of up to ₹2 lakh have been exempted from swing pricing. Details on what the thresholds and the swing factor (extent of NAV adjustment) will be worked out.
Why is it important?
In April 2020, impacted by the drying up of liquidity in the bond markets, Franklin Templeton MF sought to prematurely wind up six of its open-end debt schemes after finding it difficult to meet concerted redemption demands. This triggered outflows from credit risk schemes of other AMCs. Eventually, the RBI stepped in with special liquidity facilities for MFs.
Given that liquidity in most corporate bonds tends to be erratic in Indian markets, SEBI has decided to adopt swing pricing to avoid a repeat of this incident. A lower swing NAV can disincentivise investors from bailing out, thereby preventing the initial wave of redemptions from snowballing into a mass exodus.
Why should I care?
Swing pricing makes debt funds, especially those taking credit risk or those owning less liquid bonds, fairer for small investors. In its absence, those exiting a scheme first have an advantage over those who exit later as they may get the benefit of higher NAV. Under swing pricing, the money the fund saves by offering a lower exit NAV can help shore up value for staying investors. The need for offloading the better-quality holdings is reduced.
The bottomline
Swing pricing is set to swing the pendulum in favour of retail investors.
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