VR Logo

The last word on the JP Morgan fixed income crisis

The crisis in August has resolved itself, but everyone needs to learn from it

The last word on the JP Morgan fixed income crisis

How much harm is done by investors paying more attention to noise rather than taking a calm look at reality? For mutual fund investors, the real, financial, fallout from the problems that two debt funds faced in August has turned out be negligible (or even non-existent). However, the fallout in terms of needless worry, dubious theories about fixed income investments, and regulatory hyperventilation was considerable.

Now that the dust has settled on the whole affair, it turns out that there wasn't anything much to justify the predictions of doom. Here are the hard numbers. Let's say you had invested ₹1 lakh each in two problem funds just before the crisis hit, that is, on August 20 this year. Then, in one of them, you would have a loss of ₹500, and in the other, a profit of ₹1,000. In other words, much ado about nothing.

Let's see what the crisis was all about. Towards the end of August, JP Morgan Mutual Fund limited redemptions in two of its debt funds, the JP Morgan India Treasury Fund and the JP Morgan India Short Term Income Fund. There was a sharp drop in the NAV of these two funds because one of the companies--Amtek Auto--whose bonds that they had invested in, revealed financial problems in a subsidiary that it had hitherto concealed. The rating agency which had rated the bonds withdrew its rating and as a result, the regulatory norms mandated that the fund had to write off its entire investment in the bonds. The result was that one of the funds lost 3.4 per cent value and the other 1.7 per cent at the time. Now, one of these is a loss of 0.5 per cent, while the other is a gain of 1 per cent. The improvement is due to the fact that 85 per cent of the value in the problem bonds of Amtek has been recovered, while the rest of the portfolio is gaining as expected.

The drop in NAV in a fixed income fund--which Indian investors are not used to in short-term funds--as well as the limitation on redemptions seemed to trigger a wave of panic. As I'd written at the time, risks are inherent to mutual fund investing. Based on their track record, investors expect short-term fixed income funds to not have any volatility, but this expectation is not justifiable. Moreover, given the widespread distress that many sectors are seeing, such problems could occur in any type of fixed-income fund. However, the truth is that it can happen. In fact, given the scale of the NPAs in India's banks, it's actually a pleasant surprise that out of ₹9 lakh crore of bond investments by mutual funds, only a small amount in one company has yet turned out to have problems honouring its bonds.

As far as investor reaction at the time went, it was primarily driven by some alarmist and ill-informed media coverage that seemed to pander to the worst ill-informed fears. What made it worse was speculation about how the regulator was going to step in and make changes to how fixed-income funds are run. However, limiting exposure to individual funds and sectors cannot be the answer.

From a structural point of view, the problem is that AMCs are running open-ended funds with highly liquid one day redemption facilities backed by highly illiquid corporate bonds. If, because of some news or event, a relatively large number of investors ask for redemption in such a fund, then the AMC has nowhere to get the money from. The same news would have frozen the underlying market too. Typically, the fund manager would be forced to sell off some of the better (more liquid) holdings in the fund. That would lower the overall quality of the portfolio that is being held by remaining investors. Since fixed-income investors are professionals who would be aware of what's going on (or would surely have been made aware by rival fund companies!), there would be a run on the fund. There's no solution to this except to ensure that the liquidity offered by the fund matches the liquidity in its own portfolio.

This crisis turned out to be a storm in a teacup. However, it's important that investors, fund managers, media, analysts, as well as the regulator draws the right conclusions from it.