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Bond Fund Disaster

Fixed-income mutual funds have become an increasingly important type of investment with Rs 3.4 lakh crore worth of investors money. But they could headed for a srious crisis

Over the last ten years, fixed-income mutual funds have become an increasingly important type of investment. From a negligible asset base in 2000, these funds have grown to a huge Rs 3,40,000 crore currently. For investors as well as debt-issuers, these funds have become a de facto substitute for the vibrant bond market that India doesn't have.

Now, all that is set to collapse, perhaps in a matter of weeks. Although last week's severe liquidity panic seems to be dying down, the crisis has brought forward some fundamental problems in the way corporate bonds are valued. Having experienced last week's fear and panic, investors won't forget these problems in a hurry. The net result will be that either the business of running fixed-income mutual funds will shrink and wither away, or it will have to be completely redesigned.

The basic problem which debt funds are no longer able to cope with is quite simple. For all practical purposes, these funds are in the business of pretending that a genuine market valuation (and liquidity at that valuation) exists for corporate bonds in India. In reality, the market is so small that for all practical purposes, it doesn't exist. As long as the going was good, the lack of a real market didn't matter. However, as soon as the credit markets soured, the cracks started appearing.

As I wrote last week, debt funds have been hit with redemption requests which they have been so far able to honour with a little help from the banks. Till now, the redemption problems have largely been limited to cash and liquid plus funds, most of whose holdings are Certificate of Deposit from major banks and commercial paper from highly-rated companies. These should have been easy to liquidate, but they weren't. For the time being, the government and the Reserve Bank has opened a window for mutual funds to bridge the time between redemption and sale. In the case of bank CDs and short-term commercial paper, this liquidity bridge should do the trick, although at a huge cost to the fund companies.

However, there are other types of funds that could prove problematic. A major example is the so-called Fixed Maturity Plans (FMPs). FMPs have been designed as an alternative to bank fixed deposits, except that their returns are somewhat higher and they are more tax-efficient. They are closed-end funds which exist for a fixed period and are redeemed at the end of that period. The underlying investments are corporate bonds whose maturity matches that of the FMPs itself. However, all FMPs also offer a premature redemption option, generally after charging a load. Investors who withdraw money prematurely from an FMP get their investments redeemed on the basis of that day's NAV, just like any other fund.

This NAV should to be based on the investments' market value. However, there is no active market for most of these instruments. Therefore, the value is calculated using a methodology devised by the rating agency CRISIL, called the CRISIL Bond Valuation Matrix. This means that in practice, premature redemption from a fund holding illiquid corporate bonds will get you an NAV that is not based on real money that real buyers are willing to pay for real investments in a real market. Instead, it's an estimate. And that estimate is the output of a formula whose accuracy has never been given any kind of stress-testing. Now, on October 18, SEBI has issued a circular about the modification of the formula used to rate illiquid securities, allowing more stringent criteria to calculate their fair-value.

The problem arises when one tries to sell these "fair-valued" securities in a thin market: the actual price realised is far lower. Plus, these redemptions will probably be financed with the sale of those securities that are easier to sell, by definition the better quality ones. Those who keep their money in the funds till the end will be stuck with poor quality debt that won't be sellable for anything close to what the Bond Evaluation Matrix says that it's worth. The real problem here is that those who redeem early will be paid an over-estimated NAV that is based on assumptions estimates.

Everyone knows that the entire global credit crisis was facilitated because the real worth of debt instruments was not even close to what the fantasy formulae of rating agencies said that it should be. I believe a similar problem exists in India, hopefully on a much less disruptive scale. But it will have to be tackled head on, and soon.