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Debt funds plunge as RBI squeezes market

Medium-to-long-term govt securities schemes were the worst hit, dropping 2.52% on average

The 6.12 trillion debt mutual fund (MF) market panicked on 16 July as bond prices crashed due to the sudden move by the Reserve Bank of India (RBI) to tighten the market. Debt mutual fund (MF) schemes fell sharply on the back of rising yields in the debt markets. Medium- to long-term government securities or G-secs funds were the worst-affected; they fell 2.52% on an average. Long-term bond funds fell about 2%.

Apart from rising yields, another factor that contributed to the losses made by debt funds was a circular that the Association of Mutual Funds in India (Amfi; the MF industry’s trade body) sent out on the same day to all fund houses to mark their portfolios to market values. Typically, securities (that MF schemes hold) that mature beyond 60 days are marked to market. Securities that mature within 60 days aren’t; they are valued through an amortization method where their security value shows a steady, daily rise.

Tentative figures from MF industry officials say that banks and institutions withdrew almost 35,000-40,000 crore on 16 July alone. “Today (17 July), there doesn’t seem to be any redemption pressure on MFs," said a fixed-income fund manager, on the condition of anonymity.

Rising rates stinker

Just a day before the fall, in a bid to prevent speculation in the currency market, RBI had restricted liquidity in the debt markets by making it more expensive to borrow money. “This is a temporary move as there was a lot of speculation in the currency market. People used to borrow money from the RBI repo window, buy dollars in the morning, sell dollars in the evening and make huge gains from speculation. RBI’s move will restrict this," says Nandkumar Surti, chief executive officer, JP Morgan Asset Management (India) Pvt. Ltd.

However, it was enough to spook the debt markets as many participants saw this as a sudden reversal of RBI’s earlier stand of softening interest rates. As yields in the markets rose, prices of debt securities fell. This also led to fall in net asset values (NAVs), which further spooked institutional investors of debt funds, who made a rush for redemptions.

When interest rates rise, schemes that are invested in scrips with a longer maturity get hit the most. Long-term Bond and G-secs funds, such as Kotak Gilt Investment scheme, ICICI Prudential - Income Opportunities and Sundaram - Flexible Income schemes lost close to 4% in a single day. Liquid funds, too, lost close to 20 basis points (bps) on an average and ultra short-term bond funds lost about 45 bps, all in a single day.

Amid news of huge redemptions trickling in, several fund houses made frantic phone calls to their distributors explaining them why the carnage happened and allaying fears of investors. Elsewhere, as the debt markets were unravelling on 16 July, banks decided to withdraw from liquid funds as RBI had restricted banks’ access to easy money, just a day before. So banks fell back on their money lying in liquid funds. “We also saw some institutions withdrawing money on Tuesday (16 July) perhaps because the NAVs of debt funds were yet to come out by the end of the day; as debt market yields shot up, there was fear that debt funds would make losses. Nobody wanted to see a loss in their books and hence some companies made a rush for redemptions," says Amitabh Mohanty, head of debt strategies, Reliance Capital Ltd.

“Also, there was a fear that funds would pass on the losses to investors (losses that arise from falling NAVs) and won’t take them on their own books like it happened in October 2008. Hence, institutions are said to have withdrawn a significant chunk," said Manoj Nagpal, chief executive officer, Outlook Asia Capital, a consulting and wealth management firm.

Measures taken

Early on 17 July, RBI opened a special window for MFs to borrow from the central bank. This is a temporary window and funds can borrow for the next three days in case they face huge redemption pressure. Says Hoshang Sinor, chief executive officer, Amfi: “There have been redemptions but they are not alarming. This is a facility to give comfort to the MF industry and prevent any fire sale." The RBI’s special window for MFs is a rare measure to ensure that if funds face redemption pressure, money is available to pay off investors. Typically, MFs cannot borrow from RBI but this special window would allow banks to borrow on behalf of mutual funds.

Most fund houses we spoke to said that redemptions will continue for a few more days, but added that the numbers may not be alarming. “We see some redemption to continue and maybe money in liquid funds may not come back in the near future. But that is temporary I think. And I don’t think the MF industry will make use of the RBI window in a big way. That measure was taken proactively to instil confidence in the system," says Mohanty. He adds that Amfi’s move to nudge the MF industry to mark to market their portfolios “was a good move as the NAVs now reflect their true value. This also dissuaded investors to withdraw further, on Wednesday (17 July)".

What should you do?

Mint Money has consistently recommended avoiding long-term debt funds and G-secs as they require market timing. We still feel that long-term debt and gilt funds are risky. Besides, a tenor of at least three years is required if you wish to gain the most out of these schemes and interest rate trends have known to change direction within three years.

If you are invested in short-term debt funds, we suggest that you stay invested. In fact, if you wish to invest for up to six months to a year or two, look at a combination of fixed maturity plans or FMPs (these get to invest at current short-term yields that are high and, therefore, get to lock in higher-yielding debt scrips), ultra short-term and short-term bond funds. Though, expect volatility in debt markets in the short run.

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