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The Bond Fizzle - Why? How? What next.......

Yesterday investors faced the shocking reality -- across the board dramatic fall in NAV of Bond Funds. The genesis of the fall -- unprecedented sharp fall in gilts and rupee.

The reason -- overreaction, panic, fears of war, FIIs on the run and rising oil prices. US market closure and central bank's inaction further aggravated the bleak outlook.

Fire fighting: Reserve Bank announced liquidity infusion by Open Market Operations (OMO) and Federal Bank cut Bank rate by 50 basis points before the trading in U.S. Markets commenced after closure since Tuesday. These measures had a positive impact on the bond prices in late evening trades and they recovered back to more or less Friday closing levels. Despite the recovery of bond and gilt prices on Monday late evening, the NAVs of Income Funds have fallen from Friday levels by 1.5 to 2.0 percent.

Pricing Imperfect: The fall in bond fund values can be traced to the rudimentary valuation methodology adopted.

First, in the wake of likely exodus, funds decided to value their debt portfolio on Monday, which was usually done every Wednesday. Moreover the prices taken for valuation of gilts and traded bonds were as at 5:30 P.M. levels, whereas a major part of recovery of bond prices came after that.

Valucorp model for valuation of non-traded securities was implemented on Monday at 1:30 P.M. cut off, wherein the yields of Corporate Bonds had increased by approximately 1% from the last valuation date i.e. September 12, 2001 (Wednesday). The effect of recovery based on Reserve Bank and Federal Reserve announcements came afterwards and was not factored in the yields of Valucorp model. Thus the increase in yields from last Wednesday to mid Monday were considered but the subsequent correction was ignored in NAV calculation.

All these factors had a compounding effect to leading to unprecedented fall in bond fund NAV.

The Road Ahead: The markets will remain choppy as uncertainty prevails. However, the abnormal fall in NAVs on Monday is more a result of faulty valuation and fund's myopic view ignoring the market conditions.

Assuming the markets gain stability around Monday closing levels, it is only a matter of time that the substantial part of loss in NAV's will be recouped. This should be reflected in the Wednesday NAV i.e. on September 19, when the non-traded securities of bond funds will be valued again as per Valucorp model. At the time of writing this, government bonds were higher soothed by central bank moves to stem the volatility in the foreign exchange and bond markets. The benchmark 10-year bond, the 11.50 percent 2011, was dealt at 112.60 rupees compared with 112.50 rupees late Monday.

The Action Plan: It is important for investors not to overreact. The worst thing one can do is to sell at the bottom, which many investors did. Investors should stay with the investment strategy they had in place prior to the attack, and not lose sight of their investment goals.