Over the last fortnight, Indian debt fund investors have gone through a severe shock therapy. They've had a sudden dose of losses that they had no reason to expect and what's worse, it's clear that this is not a one-off event. Smart debt fund investors should recognise that the game has changed permanently and there is now a whole new source of uncertainty in the returns of these funds which is not going away.
Conventionally, Indian debt fund investors were used to the fact that the only potential sources of losses were either interest rate changes or defaults by bond issuers. However, neither of these was the reason for the recent upheaval. Instead, it was a massive selloff of Indian debt by foreign investors. From the 22nd May--when the exodus started--till 27th June, the outflow total about 6.85 billion dollars or about Rs 39,500 crore. To put things in perspective, not only is this outflow about4.5 times the previous largest monthly outflow, it's actually more than the total inflow from 1999 to 2008--almost an entire decade since such investments were permitted.
Over the last few years, the limit for FII investment in Indian debt has been repeatedly raised till it stands at USD 81 billion, out of which the limit for government debt is USD 30 billion. The motive for this rise has been the financing the government's borrowing binge as well as bridging the current account deficit. However, at the end of the day this FII inflow is hot money, much hotter than FII investments in equity. While much equity investment sticks around in volatile markets, bond investors have a different attitude. As long as the yield, adjusted for the cost of hedging against a weakening rupee, is higher than the cost at the source, the money stays. The moment this sum threatens to turn negative, the money rushes out.
Back when the European crisis was at its peak, there used to be frequent talk of international bond investors 'punishing' profligate, debt-ridden government by selling their bonds and pushing up their yields. At that time, analysts would note that despite our poor macros, India was mostly immune to this problem because much of our debt was domestic. While this is still technically true, enough bonds are now held by FIIs so that these sudden crashes in the bond markets are now entirely feasible. On the 20th, the debt markets actually shut down for some time because they hit a lower circuit.
While the larger implications of this new reality can be debated at another level, debt fund investors need to immediately re-evaluate whatever they have learned about debt investing all these years. Over the last one month, Value Research's income fund category has a loss of 1.27 per cent and the long-term government bond funds category is dow 1.75 per cent. For investors, coming as they did from an entirely new source of instability, these losses were a shock. I expect that many conservative bond fund investors will seriously reevaluate whether they should be invested at all in funds that specialise in these kinds of bonds. In fact, I wouldn't be surprised if a lot of them shift towards funds that focus on shorter-term bonds.
This could reduce the demand for longer-term bonds--specially government bonds--among domestic investors. Paradoxically, the net effect of this is the exact opposite of what the government had originally set out to do by opening the debt market to FIIs. But then, what can you do, the law of unintended consequences seems to have a special affinity for government actions.
Anyhow, whatever be the larger outcomes, if you are a bond fund investor, you should make an effort to understand this phenomena and adjust your strategy accordingly--and permanently.
Ask Value Research 
New episodes every Friday 
New Process Alert 
Seems like you've uploaded a wrong QR code. Please upload the QR code downloaded from MF Central platform.
