Steep fall in Debt Fund NAVs – Reasons behind Tuesday’s Bloodbath

This post is written by Shiv Kukreja, who is a Certified Financial Planner and runs a financial planning firm, Ojas Capital in Delhi/NCR. He can be reached at skukreja@investitude.co.in

A 3%+ fall in the NAV of an equity mutual fund is somehow acceptable for an investor, as I think almost every investor knows equity markets remain volatile and such a movement in either direction is part and parcel of stock markets. But, how would a risk-averse investor react to such a steep fall in a debt fund scheme?

It would definitely be a rude shock for a conservative investor, who invested in such a scheme a few weeks back, expecting at least a couple of rate cuts from RBI in the rest of the financial year and thereby to earn somewhat better returns as compared to bank FDs.

On Tuesday, July 16th, some gilt funds suffered such a steep fall in their NAVs. Other debt fund categories, such as income funds and dynamic bond funds, also suffered huge losses. Even short-term funds, ultra short-term funds and liquid funds, which are considered as the safest options of mutual fund schemes, generated negative returns for their investors.

So, what caused such a big fall in the NAVs of all these debt funds?

Indian rupee has been falling and the fall is quite worrisome as it has happened quite fast. It is also making headlines in the newspapers and people are talking about it cursing the government, so it becomes more worrisome in an election year. In order to give some strength to the falling rupee, RBI in consultation with the finance ministry and SEBI took some short-term measures on Monday to squeeze excess liquidity from the system.

What are those measures and what do they mean?

* The Marginal Standing Facility (MSF) rate is recalibrated with immediate effect to be 300 basis points above the policy repo rate under the Liquidity Adjustment Facility (LAF). Consequently, the MSF rate will now be 10.25 per cent.

* Accordingly, the Bank Rate also stands adjusted to 10.25 per cent with immediate effect.

First, we need to understand what is Liquidity Adjustment Facility and what the Marginal Standing Facility rate is?

Liquidity Adjustment Facility is a policy tool which allows banks to borrow money from the RBI through repurchase agreements or popularly called repo transactions. As the name itself suggests, LAF has been provided to aid the banks in adjusting their day-to-day liquidity mismatches. LAF consists of repo and reverse repo operations. Marginal Standing Facility rate is the rate at which the scheduled banks can borrow funds from the RBI for their overnight liquidity requirements.

So, before Monday’s announcements, the MSF rate was 8.25%, 100 basis points (or 1%) above the repo rate of 7.25%. On Monday, RBI increased it to 10.25% to make it costlier for the banks to borrow and thereby tighten the liquidity.

Moreover, most of the market participants were surprised by such moves and they are considering these announcements as a prelude to policy rate changes.

* The overall allocation of funds under the LAF will be limited to 1.0 per cent of the Net Demand and Time Liabilities (NDTL) of the banking system, reckoned as Rs.75,000 crore for this purpose. The allocation to individual banks will be made in proportion to their bids, subject to the overall ceiling. This change in LAF will come into effect from July 17, 2013.

Earlier till Tuesday, July 16th, this percentage was 2% of the Net Demand and Time Liabilities of the banking system. So, by reducing it from 2% to 1%, RBI squeezed Rs. 75,000 crore from the system and capped it at Rs. 75,000 crore only from its earlier limit of around Rs. 1,50,000 crore.

This measure made the banks and the corporates to rush to the mutual fund houses on Tuesday to redeem their investments in debt funds, especially liquid funds, ultra short-term funds and short-term funds. Such a huge redemption by these entities caused a very high supply of these securities and therefore a fall in their values.

* The Reserve Bank will conduct Open Market Sales of Government of India Securities of Rs.12,000 crore on July 18, 2013.

RBI conducted this open market operation (OMO) today evening to squeeze an additional Rs. 12,000 crore from the system, but the results of the auction were shocking. Against its notified amount of Rs. 12,000 crore, RBI received bids worth Rs. 24,279.20 crore. But, the central bank accepted bids worth Rs. 2,532 crore only and rejected the remaining bids worth Rs. 21,747.20 crore. But, why the RBI did so?

I think RBI was not comfortable with the low quotes (or higher yields) at which the bids were placed. With this rejection, RBI wants to send a message to the market participants that the measures taken by it on Monday are temporary in nature and people should not use it as an opportunity to ask for higher yields on government securities.

But, at the same time, I think the market participants are also confused and probably right in their decision to quote higher yields as they are not able to adapt to the fast changing market dynamics and really do not know what the ideal yield should be for these long-term government securities in the current highly complicated interest rate environment.

Impact on Stock Markets: RBI measures spread the negative sentiment to stock markets also as the BSE Sensex lost 183.25 points, down 0.91% and the NSE’s Nifty declined 75.55 points or 1.25%.

Impact on Rupee: The booster dose of RBI helped rupee to jump to 59.31 per dollar, up 0.97% from its previous close of 59.895.

Impact on Borrowers: The banks which were planning to cut interest rates on home loans, car loans etc. must have changed their minds by now. So, the borrowers hoping for a rate cut should cut down their own expectations for a low interest rate regime.

Impact on Depositors: Some good news for the depositors. The fear of deposit rates falling has turned into a hope of them rising for a short term. Rajat Monga, CFO of Yes Bank, said that he expects deposit rates to harden 50-75 bps in the short-term.

Impact on the Government Borrowings & Fiscal Deficit: The interest rate tightening will increase the cost of government borrowings and thus worsen the condition of our fiscal deficit. High time for the government to take some bold decisions. Just a hike in FDI limits will not make foreign investors invest in India, they should be able to foresee returns getting generated on their investments.

These are turbulent and testing times, not just for our economy, but for our markets as well, be it stock markets, bond markets, forex markets or commodities markets. The question is, at a time when most of the professional fund managers or the so-called market experts are not able to take their investment decisions, what should a normal household investor do in such a times? It is a million dollar question and again, for most of the conservative investors, investing in bank FDs is the best solution.