When you make a deposit at a Bank, you are paid a certain percentage of interest. But if you take a loan from the same bank, you pay a much higher rate of interest than what an investor gets paid. This in financial parlance is called “Net Interest Margin”.
This margin is what makes running a bank attactive. Higher the differential, Higher the income you earn and if you are able to ensure that most of your loans that are given out don’t end up becoming a non performing asset, in the long run you may also be seen as a potential candidate for the Finance Minister of the Country.
The average Net Interest Margin for Public Sector Banks is 2.4% for Public Sector Banks, 3% for the large Private Sector Banks and 3.4% for new age Private Sector Banks. Out of this goes all bad loans, all expenses incurred and any other line items before net profits are calculated. A 3% doesn’t seem like much, but banks overall create new money and hence is a leverage business. More the leverage, better the margins.
It’s a nice cosy relationship. If you are a large depositor, at best you will receive a glossy calendar and a dairy at the beginning of the year to make you feel happy. On the other hand, if you are a small borrower, you will have mostly probably pledged your body and soul to get the working capital you require for the business. A large borrower can command better terms but there is such a fight for them that they know that they can get away with the lousiest of collateral – even figments of imagination in some cases.
Your Margin Is My Opportunity is a famous quote by Jeff Bezos. Amazon over the years has turned out to be a bull in a china shop. Previously great companies were grounded when they confronted Amazon. Personally, as an avid book buyer, it’s been the best thing to happen for me. The cost has been borne by those who were either unprepared or did not have the capital to compete with the giant.
In a way, Mutual Funds and Non Banking Financial Companies, better known as NBFCs have been the disruptor in recent years. Being smaller in size and more nimbler, they were able to take away the cream leaving the rest to be fought over by banks.
The reason for NBFCs to exist is basically because of lacunae by larger banks when it comes to lending to the risky segment of markets but one whose are small in ticket sizes or risk seemingly large. They basically borrow from Banks (and used to from Mutual Funds too) and lend it out with the profit being the difference they can make.
One of the biggest reasons for Debt Mutual Funds to exist as a category essentially comes down to one aspect – taxation. Today, you can buy Government Securities directly. But without a Mutual Fund wrapper to protect you, the interest you earn from lending to the safest entity out there is taxed at your bracket (as is the case with Fixed Deposits at Bank).
When we talk of risks, you can divide it into 2 categories – Credit Risk and Interest Rate Risk. What happened at Franklin and we shall come there in a moment was Credit Risk that blew up in their face.
Corporates are the biggest users of Debt funds since Current Accounts where they have their monies don’t provide interest while FD’s offer lower returns (for the shortest duration) than comparable liquid funds.
The biggest attraction to Debt Mutual Funds lies in the fact that there is no middle man to take away the cream of the returns. What the mutual fund earns is what you get (post the expense ratio). If a Mutual Fund is able to lend at 10%, you get 10% (minus expense as usual) versus getting 4% in a Fixed Deposit. You see the attraction, right.
As of 31st March 2020, this was the split among debt funds (16 styles).
Pure Credit Risk funds – funds that are meant to take credit risks comprise just 5% of the total assets under management. Some of the funds performance there is so bad that someone said that they should be renamed as Capital Risk Funds.
The bigger risk and one that Franklin showcased was not about Credit or Interest Rate but Liquidity. This risk is there for any firm that takes deposits from the public to lend it further but has to pay back the depositor on demand.
On the NSE, around 1500 stocks trade every day. Mutual Funds on the other hand are concentrated more or less in the top 400. It’s not that the rest of the stocks are worthless, it’s just that the liquidity is so poor that fund managers will rather ignore such stocks than own something they cannot easily sell in a hurry.
Debt is even less liquid with very few securities carrying the ability to be sold any day without having to resort to a fire sale. When DSP sold their DHFL funds at a yield higher than the rate at which the previous deal happened triggered speculation and while the core had rotten inside, this precipitated the fall of DHFL from what once was a AAA rated firm to D as was the case with IL&FS before.
Having to provide instant liquidity is the bane for any fund. Yes, it’s easy to just go with the flow and buy only Debentures of the highest rated firms or just deposit with Banks, but that solves no problem for anyone other than being a way to arbitrage the tax disadvantage.
Since the Franklin debacle, reams have been written on that episode with 90% of the blame being attributed to the fund manager and 10% to investors who were foolish enough to risk money on a strategy that was bound to fail. While its right to blame the fund manager for the omission and commissions of the fund, the overwhelming finger pointing will mean that Debt funds will never be the same again.
Debt funds as a category is not going anywhere till the tax arbitrage is removed, but what will happen for sure is that like in equity mutual funds, much of the funds will concentrate most of their portfolio on a select few companies they believe are worth taking risk upon. If even that is seen as too much of a hassle, enterprising fund managers will just place a fixed deposit with banks and collect his fee.
