How the 2020 debt fund crisis is a repeat of 2008: Can this be avoided?

Published: May 13, 2020 at 10:39 am

Last Updated on May 11, 2024 at 6:56 pm

The mutual fund industry lost 16% equity AUM bet Jan 31st 2020 to April 31st 2020. It also lost 14% debt AUM! While a good part of the equity AUM fall was due to the crash, the debt AUM fall was primarily due to redemptions triggered by the crash and associated fear. This is how the 2020 debt fund crisis is a repeat of the 2008 global financial crisis. Can this be prevented?

Today if you wished to sell a closed-ended mutual fund like a fixed maturity plan (FMP), you will have to sell it only in the secondary market (where there are no buyers!). In 2008, one could pay a huge exit load and sell the FMP to the AMC mid-term.

As the 2008 global financial crisis raged, big investors pulled out of the MPs. At least some of these FMPs had unlisted bonds and AMCs could not sell these. Faced with redemption pressure, and difficult borrowing with high rates of interest, RBI opened a line of credit for the AMCs via banks.

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In this livemint interview, on conditions of anonymity, a debt fund manager explains how the crisis panned out and how AMFI and SEBI worked with RBI for the bailout. Any losses to the AMC were absorbed by the Sponsor (except notably Mirae).

First it was a crisis of liquidity. Then, it became a crisis of confidence. The latter hurt more than the former

In Sep 2008, Outlook Money warned about the credit risk in FMPs and the nature of bonds in their portfolio. The article has a quite by a certain Santosh Kamat:

It’s always better to sacrifice a little bit of return if you are offered a quality portfolio

Long-standing corporate clients suddenly bailed on the AMC leaving them in the lurch. Those were the days of “indicative returns” in FMPs and as usual, it hit the investors who remaining investors hard.

All this sounds eerily familiar to what happened to Franklin AMC forcing them to close six open-ended funds does it not? It is quite likely a few other AMCs faced similar issues but to a lesser extent … so far.

In Dec 2008, the above crisis forced SEBI to modify FMP rules, removing the exit load and allowing exit only via the secondary market.

Readers may recall the money market (which includes overnight, liquid and ultrashort term bond segments) suffer a mini-crisis in March 2020: Why Liquid funds and money market funds also fell in the last few days. This was because of a sudden drop in demand (sellers exceeded buyers) and the bond prices (therefore NAV) fell.

The money market situation in Sep, Oct 2008 was significantly higher in magnitude (consider the then-size of the industry). Reuters reported debt fund redemptions of  45660 Crores in Aug 2008.

This amount is about 4% of the drop in total debt AUM from bet Jan 31st 2020 to April 31st 2020. Interestingly, the total mutual fund AUM (equity + debt) was about five times smaller in 2008.

Liquid funds and liquid-plus funds (the earlier avatar of ultra-short-term funds)  that were invested in low-rated commercial papers also faced redemption pressure from MPs.  This panic also affected funds with better-quality portfolios. See: How Safe Are Your Liquid Funds? (Outlook Money dated 19th Nov 2008) and where has all the money gone? (Livemint dated Oct 13th 2008 for a general overview of the crisis).

Much of what happened in 2008 has also repeated in 2020.  The liquidity dried up fast in March 2020. Liquid funds were not marked-to-market in 2008 (except Quantum Liquid) unlike now. The demand-supply mismatch lead to a prominent drop in the NAV of all money market funds (incl liquid and ultra short-term) in Mar 2020. RBI’s quick action reversed the fall.

The MF industry (except Franklin’s high credit risk funds) has so far managed to stay afloat. Is this a sign of better fund portfolios and at least a marginally higher bond liquidity or is it only because the “cash is king” sentiment and fear is lower now than in 2008? We do not know yet. At the present time, my vote is for the latter.

The redemption crisis hit Franklin the worst because their portfolio was perceived to fail the most in the coming months and given its illiquid nature, institutional investors wanted to be the first out of the door.

Franklin was undone (as usual) by the big-players who had no issue with the high-credit risk for years enjoying significantly higher returns but hit the exit button when they sensed trouble. Financial markets are brutal.

It cannot be denied and should not be forgotten that the fund management never suffered an exclusive credit event in their custom arrangements with borrowers (over-the-counter transactions that are not listed).

This is not a case of fraud or conspiracy. With the full benefit of hindsight, armchair critics may announce “I told you so” on Twitter. How many warned about redemption pressure from a portfolio with credit risk?

While this is cold-comfort for the affected retail investors with money stuck up in the locked funds, we must also appreciate lending to low-rated borrowers is vital for economic growth cannot be wished away.

So what is the solution? Can this redemption pressure be prevented? No. It can be partitioned. As mentioned in the videos linked below, the govt and SEBI are keen on increasing participation in all sections of the bond market, not just gilt and AAA.

Not only did SEBI dilute the mandates of corporate bond funds and banking and PSU funds with a modified circular, but it also reversed it decision on unlisted NCDs allowing a fund to hold up to 10%.

Unless the big investors are kept away from retail investors, this problem will resurface each time there is fear and panic. Investors who are rushing to the safety of bonds will first come to liquid funds after they start giving high returns when the rates increase. Then they will be brave enough to take on credit risk and rejoice at their “better than FD returns”. One fine day, the big players will exit the fund it will be a case of Caramba! Back to square one! (From Tintin, The Broken Ear).

So unless different exit loads, different minimum investment amounts and different min balance requirements are set for at least low-rated debt fund portfolios, the corporate investors cannot be separated from retail.

Personally, this has been a case of “those who do not read history are condemned to repeat it”. I did not bother to educate myself about the 2008 debt fund crisis (in spite of an opportunity in July 2013 when RBI action crashed the bond market – see video below)

From “a debt fund taking on credit risk can suffer credit events (individual bond failures)”, my risk appreciation has become (unfortunately after the event):

A debt fund taking on credit risk can suffer credit events (individual bond failures) and/or redemption pressure in the case of wide-spread fear and panic.

Redemption pressure can hit any debt fund, but the first victims clearly are those with low-rated bonds.

This is a taping of a talk given to Tamil Nadu Investor Association Members about the Franklin crisis on May 9th 2020 in three parts.

Part 2

Part 3





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