ON FUNDS ROUTE Capital protection gains currency

The market for equity-linked debentures appears to be looking up as strong returns from stock markets appear difficult from present levels. However, it will be a while before these schemes gain the fervour seen in the heady days before the crash of 2008, feels Santosh Nair

TILL THREE years ago, capitalprotected schemes were in vogue. The novelty of this product was that it promised (subject to a host of conditions in the fine print of the offer document) to protect investor's capital, while at the same time offered a pre-defined percentage of the upside in the stock market. The instrument, also known as equity-linked debentures (ELDs) in market terminology, was issued by the non-banking finance arms of large financial services firms, notably foreign banks such as Citi, Merrill Lynch, Deutsche, Barclays and JPMorgan. Share prices appeared to be over-heating towards the latter half of 2007, and many wealthy individuals along with some of the not-so-wealthy investors were keen to grow their money earned from the bull market, but without risking their principal. These capital-protected schemes seemed to be just the right answer to their requirement. Sensing an opportunity for juicy fund management fees without undue risks, some mutual fund houses too began offering this product. They would collect money from investors and invest the entire corpus in equity-linked debentures issued by the NBFC arms of large banks.
    Three years on, conditions once again appear favourable for capital protection schemes. Fund managers and brokers feel share valuations are expensive relative to historical average, and the risk of a sharp correction is high, given the fragile mood in world markets.
    The market for ELDs has started warming up, and there have been quite a few issuances in the past few months. Issuers, though, admit that the size of the market is smaller than what it used to be at its peak three years back. As these debentures are privately placed, there is no exact data available. But officials at three foreign banks whose NBFC arms issue this product, estimate the market size to be around $1-1.25 billion currently, compared to around $2 billion around the time the stock market peaked in 2008. Issuers cite different reasons for this trend.
    "These products (capital-protected schemes) are issued by NBFCs to meet their capital requirements," says a senior official at one of the ELD-issuing non-banking finance company. "Till two years back, these firms had huge appetite for funds. Since then, they have trimmed their balance sheets by a god measure, and they no longer require that kind of funds. That is the key reason why the ELD market has shrunk," he says.
    But there are other reasons as well. Domestic mutual funds, once big buyers of ELDs, have all but turned their backs on this product following the financial markets crisis in 2008. They now mostly buy only the nonconvertible debentures issued by NBFCs.
    Fund managers say they have become wary of fancy derivative structures in general, after the money market crisis of October 2008, which saw investors in liquid schemes suffer a loss of capital.
    In a typical ELD, the NBFC which raises 100, lends 75% of it at 12-14%, which then grows to 100 in three years. The remaining 25% is then deployed in index futures and index options (or stock futures and stock options, depending on the underlying to which the returns are linked) to capture a promised percentage of stock market returns.
    Last week, the Securities and Exchange Board of India issued guidelines for mutual funds barring them from not only writing option contracts, but also restraining them from purchasing "instruments with embedded written options."
    Some NBFC officials say this rule is ambiguous, but unless clarified, mutual funds will not buy capital-protected schemes. Some other officials say the rule is ridiculous. "What is the interpretation if a mutual fund buys a fixed coupon rate bond, which usually have put and call options. Should they stop buying them as well?" asks an official at a foreign bank. Industry officials say, globally, wealth management firms, asset management companies, corporates and sophisticated individual investors are the biggest buyers of structured notes—the generic term for any customised financial product comprising multiple asset classes.
    They say, in India, this market is likely to grow at a sedate rate, unless the current regulations are amended. "Insurance companies, and now even mutual funds, cannot buy this product because of regulatory issues. So whatever growth, has to come from high net worth individuals," says an official at one of the foreign bank-controlled NBFCs. "Today, structured notes comprise 5% or less of a wealthy individual's portfolio. Going forward, at some point, it might become 10% and even 20%. That is when this market will take off. For that to happen, interest rates have to moderate. These products are a big hit overseas because the interest rates there are very low, and investors have to take risks for getting better returns," he added.
    Today, portfolio managers, including asset management companies, which manage the money of their high net worth clients, are the major buyers of ELDs.
    Some market watchers caution that even high net worth individuals who subscribe to these products do not fully understand the features. Besides, the high commission on the product is a major reason why broking firms push the product to their wealthy clients, they add. "These do not fall under the purview of the Reserve Bank or Sebi," says Rajeev Thakkar, chief executive and director, Parag Parikh Financial Advisory Services. "Also, the credit risks are not fully understood. The common assumption is that the foreign parent will stand guarantee if there is a credit default, which is incorrect," Mr Thakkar adds. On their part, the NBFCs claim that the product is unregulated because it caters to investors with a large ticket size and is a privately-placed instrument. But they add that "regulatory acknowledgement" would be a good thing for the product because it could then be offered to a larger audience.
    According to Thakkar, regulation is needed because the market will keep expanding, and with that, related risks too could increase over a period.
    "There should be disclosures on the end use of the funds, and also limits on how much leverage the firms issuing such products can take," says Mr Thakkar.
    santosh.nair@timesgroup.com