The Background
SEBI has been bringing in various
risk mitigation measures in debt funds since the IL&FS crisis unfolded in
late 2018. The debt fund crisis that started with IL&FS in 2018 and
subsequent defaults by large corporates were starting points. 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. 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.
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. 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.
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).
Investigations
by SEBI later found that large-sized redemptions were made by insiders a week
prior to the official announcement of winding up.
Typically, informed investors, be they high net worth
individuals or institutions manage to exit, even as retail investors get left behind
with a portfolio of illiquid securities. A swing factor applied on the NAV
protects retail investors from bearing the brunt of a fall in NAV due to such
exits. In its recent consultation paper, the market regulator has proposed
introducing the concept of swing pricing in open-end debt funds
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.
The Swing Pricing mechanism
Swing pricing is an adjustment made to the
published Net Asset Value or NAV of a mutual fund during extreme circumstances.
Thus Swing pricing refers to
the process of altering a fund's net asset value (NAV) to efficiently pass on
transaction costs of significant inflows or outflows to the investors
associated with such activity. It's designed to protect long-term investors
from value erosion of their fund holdings due to the action of others within
the same fund. It is a process of adjusting
a fund's net asset value (NAV) to pass on the transaction costs of significant
inflows or outflows to investors associated with such activities.
Generally, swing pricing
refers to a process for adjusting a fund''s net asset value to effectively pass
on transaction costs stemming from net capital activity to the investors
concerned.
In a
liquidity-challenged environment, quoted bid/ask spreads and overall trading
cost can widen and may not be representative of the executed prices that can be
achieved in the market.
SEBI had floated the related consultation paper (July 2021). As of now, SEBI has
proposed to mandate a swing pricing mechanism in high-risk debt funds during
market dislocation, while it will be optional during normal market time.
However, at a later stage, the regulator will examine the applicability of the
mechanism to equity and hybrid funds. The swing pricing
mechanism allows fund houses to adjust a scheme’s NAV in response to inflows
and outflows, protecting long-term unitholders from value erosion during heavy
redemptions.
Significance
of Swing Pricing Mechanism
During a liquidity crunch or in reaction to
specific events, large investors in debt funds may pull out their money. When
this happens, existing investors get adversely impacted as good-quality liquid
securities would have to be sold to meet redemption requests. So, the
proportion of illiquid securities in the portfolio rises. SEBI has now mandated
that such large outflows happen at a price that is 1-2 percent below the
current NAV.
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.
In situations where market liquidity dries up temporarily
or there are stressed securities in a mutual fund portfolio, swing pricing can
be used. It is like an exit load if investors want to make large withdrawals
during market dislocations or liquidity issues. The objective here is to pass
on any additional transaction costs arising from large outflows to the ones
redeeming rather than the staying investors.
While the
concept is new here, swing pricing is a rather common buffer globally. Swing pricing is already practised in the US,
Luxembourg, Hong Kong, France and the UK.
When large outflows happen during times ofmarket stress, the fund manager is forced to sell high-quality and liquid
papers to meet redemptions. This leaves other investors with a portfolio of
lower-quality and illiquid papers. Thus, investors staying put have to bear the
brunt of subsequent defaults.
Therefore, swing pricing works like a “circuit
breaker" for mutual funds, as it increases the cost of exiting schemes,
discouraging large investors from sudden redemptions.
The framework was earlier supposed to come into
effect from 1 March 2022. SEBI has deferred the implementation of swing pricing framework
for mutual fund schemes to May 1, 2022 on the request of the Association of
Mutual Funds in India (AMFI).
SEBI had announced the
introduction of swing pricing mechanism in India in September 2021.
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.
Oftentimes, during distress in the market, for example in a
liquidity-challenged environment, investors rush to exit from funds, thereby
forcing managers to liquidate quality bond holdings. This is detrimental to the
interest of existing investors, as they are left with lower quality bonds. So,
to safeguard remaining investors from any potential loss, swing pricing will
come into effect. Here, existing investors will end up redeeming at a value
lesser than the prevailing NAV, thereby bearing additional transaction costs.
Process of Swing Pricing
Swing pricing is of two types -
full and partial. SEBI has introduced a hybrid model - partial swing during
normal times and a mandatory full swing (in high-risk debt funds) during the
time of market dislocation. 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 partial swing pricing, a fund's NAV is adjusted when the net
inflows/outflows breach a certain pre-determined swing threshold (usually set
as a percentage of AUM). The NAV is adjusted by the swing factor if the net
inflows/outflows are above the swing threshold.
So, if net inflows exceed the swing threshold, the NAV will be adjusted upwards
for the swing factor, and in case of redemptions breaching the threshold, NAV
will be adjusted downwards. This adjusted NAV then effectively becomes
applicable for all entering and exiting investors.
For normal times, SEBI has askedthe AMFI to describe broad parameters to determine thresholds for triggering
swing pricing and an indicative range of swing thresholds. Having said that,
AMCs can have other parameters considering the nature of funds. Swing pricing
will be optional during the normal market time and if the AMC desires to
implement the same, then it will have to disclose it in the Scheme Information
Documents (SIDs) and the same will be considered as a fundamental attribute
change of the fund.
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. In
full swing pricing, a fund NAV is adjusted (swung) up or down every trading
day, irrespective of the size of investor dealing.
As per the circular, the minimum swing factor will range
from 1-2 per cent during the time of market dislocation, depending on funds'
risk profile as determined by the risk-o-meter and potential risk-class matrix.
SEBI has asked the Association of Mutual Funds of India
(AMFI) to makes its suggestions about the key parameters and triggers and develop a set of guidelines to determine
market dislocation. Once market dislocation is declared, SEBI will notify that
swing pricing will be applicable for a specified period.
The SEBIcircular defines the minimum swing pricing in case of debt funds with
pre-determined risk criteria. For example, in schemes where both duration risk
and credit risk are low, the swing factor is optional. On the other hand, in
schemes that have high duration and credit risks, the minimum swing factor to
be used is 2 percent. Based on duration and credit risk, SEBI has suggested
minimum swing factor for nine different combinations, of which three have an
optional swing factor and for the other six minimum swing factor ranges from
1-2 percent.
SEBI has released the
minimum applicable swing factor for funds depending on the risks associated
with them. Funds with low credit risk and high interest risk will have a
minimum swing factor of 1%. Similarly, schemes with high credit risk and high
interest rate risk will have a minimum swing factor of 2%. Refer to this chart
for more details:
Credit Risk
- Class A (CRV >=12):
Relatively low credit risk
- Class B (CRV >=10):
Moderate credit risk
- Class C (CRV <10) : Relatively high credit risk
Interest Rate
Risk
- Class I : (MD<=1 year): Relatively
low-interest rate risk
- Class II : (MD<=3years):
Moderate interest rate risk
- Class III: Any Macaulay
duration: Relatively high-interest rate risk
Interest rate risk ismeasured by the Macaulay Duration of the scheme while Credit Risk will de be
denoted by Credit Risk Value (CRV). The schemes will be placed in a nine-grid
box which will denote the Potential Risk Class matrix (PRC).
The Credit Risk Value
of the scheme will be the weighted average of the credit risk value of each
instrument in the portfolio of the scheme, the weights based on their
proportion to the assets under management (AUM).
Similarly, Macaulay
Duration at the scheme level will be the weighted average of the Macaulay
Duration of each instrument in the portfolio with the weights being based on
their proportion to the AUM. The value of the debt instrument to be considered
for calculating AUM has to include the accrued interest i.e. dirty price of the
instrument.
The debt securities
will be assigned a numerical rank from 13 to 1 based on their credit rating.
For instance, G-Sec/State development loans/Repo on Government
Securities/TREPS/Cash are assigned a value of 13. AAA securities get a value of
12, AA+ get 11, while below investment grade get a value of 1. Higher the
credit rating higher the value and vice versa.
For instruments having
short term ratings, the credit risk value shall be based on the lowest long
term rating of an instrument of the same issuer (in order to follow a
conservative approach) across credit rating agencies. However, if there is no
long term rating of the same issuer, then based on credit rating mapping of
Credit Rating Agency (CRAs) between short term and long term ratings, the most
conservative long term rating has to be taken for a given short term rating.
If an open ended Short
Duration Fund wants to invest in securities such that its Weighted Average
Macaulay Duration is less than or equal to 3 years and its Weighted Average
Credit Risk Value is 10 or more, it would be classified as a scheme with
‘Moderate Interest Rate Risk and Moderate Credit Risk’.
The maximum swing factor will be decided by the
AMCs based on the broad guidelines of AMFI.
Swing Pricing under Normal Market
conditions
AMCs will have to put in
place policies and procedures pertaining to swing pricing which are approved by
their board and Trustee. The scheme performance shall be computed based on unswung
NAV.
During normal times, the industry body Association of Mutual Funds
in India (AMFI) will prescribe broad parameters for determination of thresholds
for triggering swing pricing which will be followed by the asset management
companies (AMCs).
For normal times, AMCs
will decide on the applicability of swing pricing and the quantum of swing
factor depending on scheme specific issues. These need to be disclosed in the
Scheme Information Document (SID).
The
applicability of swing pricing under normal market conditions is optional for
asset managers. However, the criteria and parameters that determine the
applicability of swing pricing need to be included in the scheme information
document (SID) beforehand. Details such as the threshold for triggering swing
pricing, the range and other broad parameters are sought to be prescribed by
AMFI. Apart from what AMFI prescribes, AMCs can have their own criteria as
well.
SEBI further said
disclosures pertaining to NAV adjusted for swing factor along with the
performance impact need to be made by the AMCs in a prescribed format in their
SIDs and in scheme wise annual reports and abridged
summary.
The same may be disclosed on their website prominently only if the
swing pricing framework has been made applicable for the said mutual fund scheme.
Swing Pricing
for market dislocation
AMFI will establish a set of guidelines for identifying
market dislocation and will suggest it to SEBI. SEBI will evaluate if there is
a "market dislocation" based on AMFI's recommendation or on its own.
When a market dislocation is announced, SEBI will notify investors that swing
pricing would be in effect for a set length of time. The swing pricing
structure will be mandated exclusively for open-ended debt schemes excluding
overnight funds, Gilt funds, and Gilt with 10-year maturity funds following the
declaration of market dislocation. For conditions of market dislocation, swing
pricing can be applied on open ended debt schemes with high or very high risk,
as per SEBI’s risk o meter.
The schemes stated in para II(b) of the SEBI circular will be subjected to a minimum swing factor
as follows, and the NAV will be adjusted accordingly. Within three months of
the date of this circular, all open-ended debt schemes except overnight funds,
Gilt funds, and Gilt with 10-year maturity funds. As a result, swing pricing
acts as a "circuit breaker" for mutual funds, increasing the cost of
departing schemes and preventing major investors from making rapid withdrawals.
Subsequent to the
announcement of market dislocation, the swing pricing framework will be
mandated only for high risk open-ended debt schemes as they carry high risk
securities compared to other schemes.
SEBI said all theopen-ended debt schemes (except overnight funds, Gilt funds and Gilt with
10-year maturity funds) will have to incorporate the provision pertaining to
mandatory swing factor in their offer documents within three
months.
When swing pricing
framework is triggered and swing factor is made applicable (for normal time or
market dislocation, as the case may be), both the incoming and outgoing
investors will get net asset value (NAV) adjusted for swing factor.
All AMCs will have to
make clear disclosures along with illustrations in the SIDs including
information on how the swing pricing framework works, under which circumstances
it is triggered and the effect on the NAV for incoming and outgoing
investors.
To
insulate (to a certain extent) retail investors and senior citizens from the
applicability of swing pricing, SEBI has exempted redemptions up to Rs 2 lakh
for all unitholders and up to Rs 5 lakh for senior citizens from this
mechanism. Swing pricing will be made applicable to all unitholders at PAN
level.
Examples for Swing
Pricing
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 twoNAVs--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.
To explain swing pricing with an example, assume a fund with NAV
of Rs 200 and a swing factor of 1 per cent of the NAV with a swing threshold of
5 per cent of the fund's net inflow or outflow. If the fund witnesses a net
inflow of 10 per cent of AUM, the NAV will be adjusted upward to Rs 202. Thus,
the investor entering the fund will get to bear the associated cost. Now,
suppose the fund sees a 10 per cent redemption. In that case, the NAV will get
downward adjusted to Rs 198, preventing those redeeming earlier, anticipating a
market dislocation, from benefiting at the cost of existing investors. However,
if a net inflow or outflow of less than 10 per cent occurs, then the swing
mechanism is not implemented, and the fund's NAV stays at Rs 200.
Swing pricing
calculation is based on swing factor, which is a predetermined percentage. If
the swing factor is 2%, then the investor's redemption value will broadly be
this — (98% of NAV) x number of units.
98% was arrived at by
deducting the swing factor from 100. If the swing factor would have been 1, the
percentage would be 99.
Suppose, the NAV is Rs
20 and the number of units being withdrawn is 500, then the final amount will
be (98% x 20) x 500, which is equal to Rs 9,800 instead of Rs 10,000 (NAV x
units) during normal times.
This kind of NAV adjustment helps significantly reduce redemptions
during stress periods. Additionally, it reduces first-mover advantage as the
costs that exiting investors impose on the fund are borne by them. Thus, this
mechanism ensures more equitable treatment of entering, existing, and exiting
investors.
Another
Example Using Swing Pricing
Swing pricing is implemented if a fund’s net inflows or outflows
exceed a preset level as determined by the fund provider. In all instances, the
provider calculates the NAV as
normal before adjusting it by the designated swing factor.
Here’s a simple example: XYZ Fund has a price of $20 per share and the
fund’s provider sets a swing factor of 0.1% of the NAV for net flows above or below 5% of the
prior day’s price. If the fund experiences a net inflow of 10% of NAV, the price of the fund would be adjusted upward
to $20.02 ($20 + ($20 * 0.1%)). The same situation would occur with a 10%
outflow except that the price would be adjusted downward to $19.98. If a net
flow of less than 10% occurs, swing pricing is not implemented and the fund’s
price remains at $20.
In order to understand how NAV is determined, check here.
Full
Swing vs. Partial Swing
Funds can implement a full swing or partial swing methodology.
With full swing, the NAV of the
fund is adjusted every trading day for the net asset change regardless of how
large or small it is. With partial swing, the NAV is only adjusted if the predetermined
threshold is reached. The example used earlier would be an example of partial
swing pricing.
Swing
Pricing vs. Fair Value Pricing
Swing pricing is not the same as fair value pricing, and it’s
easy to get the two terms confused. Here are two major differences:
- With fair value
pricing, a security’s price is adjusted to an estimated current value if
the most recently traded price is considered out of date or stale. On the
contrary, swing pricing adjusts the NAV of the fund to account for the costs
of high volume buying or selling.
- Fair value pricing
occurs at the security level, whereas swing pricing occurs at the
portfolio level.
Limitations
of Swing Pricing
While
swing pricing has generally been an effective tool, it may not cover allliquidity scenarios adequately. Swing pricing only applies a percentage factor
to larger flows. In the event of a significant liquidity crunch, the swing
factor may not necessarily cover all transaction-related costs. In this
situation, long-term shareholders may still be impacted by these trading fees.
When
a partial swing pricing method is used, large flows could still occur that may
not be large enough to initiate the swing pricing process. Again, long-term
shareholders may feel some minor impact. Therefore, swing pricing policy needs
to be monitored and reassessed on a continuous basis to ensure it remains
effective
Conclusion
Aimed at safeguarding the interest of investors during stressful times, it is
certainly a welcome investor-friendly move. Having said that, a few open-endquestions do remain like appropriate parameters for swing pricing, swing
threshold, etc.
The problem
it does not solve is of investors being left behind with an illiquid portfolio
if these large sized redemptions do happen even after a swing factor is
applied. A swing factor adjusted NAV will not make the portfolio quality better
or prevent the adverse impact of holding illiquid securities.
The criteria and
parameters for triggering swing pricing should be standardised by AMFI, with
little ambiguity.
Communication around
application of swing pricing on days of market dislocation needs to be timely
for it to be effective. It’s unclear whether SEBI or AMFI will be responsible
for this communication.
The range of swing pricing may
be a cause for concern for asset managers during a low interest rate
environment, when debt fund yields are relatively lower. The minimum swing
pricing adjustment is given as 2 percent for high-risk categories, which can be
a huge penalty if the annual yield of the scheme itself is in the range of only
7-8 percent.
Swing pricing makes debt funds, especially those takingcredit 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. Swing pricing is set to swing the pendulum in favour of
retail investors.
