There aren't too many bright spots so far in the financial crisis, but one of them is the way the massive redemptions from debt mutual funds have been managed so far. About three weeks ago, it had looked like Indian debt funds were heading for a major crisis. Investors were looking ready to redeem their money in large amounts. That would have been fine in normal circumstances but the global financial crisis has made the situation anything but normal.
Here's a recap of what I wrote at the time. The problem which fund companies were facing was quite simple. They are running mutual funds from which investors could withdraw money at any time. However, investors' funds were invested in bonds that weren't easy to redeem quickly. Most such funds kept some part of the assets in investments that should have been easy to sell quickly. For all practical purposes, these funds operate as if a genuine market valuation (and liquidity at that valuation) exists for corporate bonds in India. In reality, the market is practically non-existent. As long as things were normal, the lack of a real market where any bond could be redeemed at any time didn't matter. However, as soon as the credit situation worsened, the cracks started appearing and the normal definition of 'easy to sell' broke down. Moreover, as businesses started worrying about their cash levels, the volume of redemptions also rose way above normal. For a few days, even assets that should have been the equivalent of cash became impossible to redeem. Certificates of Deposit from major banks and commercial paper from leading companies could not be sold.
However, things have gone more smoothly than expected since that time, despite the fact redemptions have been on a massive scale. The Reserve Bank and the government has made temporary bridge finance available for funding redemptions. This sum was initially Rs 20,000 crore and was later raised to Rs 60,000 crore. The government also made sure that CDs of all banks were honoured as collateral against getting funded from this source. Apparently, mutual funds have used less than a quarter of this funding facility so far. All in all, more than Rs 1 lakh crore of debt funds have been redeemed so far. None of the fears of investors have come true. Some FMPs dropped NAVs for investors who withdrew funds prematurely. In the liquid plus category, two relatively small funds recorded losses. Still, the liquid plus type of funds are supposed to be ones where there's a bit of extra risk for the promise of some extra returns.
However, I believe that the experience of these last few days will change the fund industry for ever. It is true that what has happened is a once-in-a-lifetime 'Black Swan' event that was hard to predict. However, it has brought to sharp relief some of the contradictions in the way this business is being done in India. While the funds are squeezing out of a tight situation by using the RBI's lifeline, fund companies are paying a heavy price as interest.
Moreover, the debt fund business that once looked like so straightforward has been seen to have many hidden pitfalls. By taking short-term deposits and lending them out long-term, mutual funds were substituting for the bond market that India doesn't actually have. I think that many fund companies will go in for a very fundamental rethink of their business models. The business of running debt funds doesn't look very attractive any more. Taking the trouble to build a retail-oriented equity customer base suddenly looks like the better thing to have done.
When we finally emerge from this crisis, I wouldn't be surprised to see fewer, smaller, but more robust and more profitable fund companies.