The present liquidity crisis in short-term debt mutual funds could precipitate a flight to safety for a long time to come
It?s no secret now that mutual funds of the short-term debt variety are having trouble meeting redemption requests from investors. These types of mutual funds are typically used by companies as short-term substitutes for bank deposits. Very few retail investors invest in them. And these markets also have nothing to do with the equity markets. These short-term debt funds invest their corpus in corporate bonds and bank certificates of deposits.
Starting around October 10th, a crisis has developed in these funds. As money has become tight, many fund companies have found it difficult to sell the underlying investments to honour redemptions. On October 14th, the Reserve Bank of India (RBI) announced the creation of a special Rs 20,000 crore credit facility to help these funds bridge the gap between redemption requests and the actual sale of the underlying assets. According to what the RBI has stated so far, this facility is temporary and will be available for 14 days. Other measures have also been taken. A large part of the holdings of such funds are in certificates of deposits (CDs) of banks. The RBI has permitted banks to allow premature redemptions of these CDs, something which is not normally done.
The most important contribution that the government and the Reserve Bank are making is that of building confidence. These actions, as well as statements made by the Finance Minister himself, have made it clear that the government considers mutual funds to be a crucial part of the nation?s credit markets and is prepared to stand by them. The actual details are important but this de facto recognition of the role that funds play in the nation?s financial infrastructure is an important step forward.
Will the measures work?
But will the steps announced so far work? Certainly, these steps will solve the immediate problem over the next few days. Beyond that, there are two possible scenarios:
The bad scenario. The liquidity crisis could snowball and redemption demands could persist. Sooner, rather than later, a large part of the almost Rs 1 lakh crore that investors have put into corporate debt through open-ended mutual funds will need to be unwound. Unfortunately, there is a fundamental and unsolvable liquidity and maturity mismatch between the lender and the borrower here.
Fund companies have created products where investors have a right to pull out their money on demand at any time. However, the investors? money is actually trapped in bonds that can?t be redeemed on demand. As a result, redemptions can only be honoured if other investors buy the bonds. Do these willing buyers exist? I?m not so sure. Today, almost anyone who has any money seems to have decided to keep it under the pillow. It?s difficult to tell when this attitude will change.
The good scenario. The fact that the government is standing behind redemptions will restore confidence and that in itself will reduce redemption calls. In a few days or weeks, things will be back to normal. Or not.
It is likely that ?normal? is going to be redefined in the debt markets. The fixed income investor, by definition, has a cautious attitude. Attitudes towards fixed-income assets are bound to undergo a sea change. Credit markets in India could well see a wholesale flight to safety for a long time to come, just as in the rest of the world.
