Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation. This blog is currently suspended.

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Tue, 28 Apr 2020

Indian corporate bonds need a buyer and not a lender

The Reserve Bank of India (RBI) announced yesterday that it is setting up a Rs 500 billion Special Liquidity Facility for Mutual Funds (SLF-MF). This is basically a refinance window for banks that lend to mutual funds to help them handle redemption pressures in an environment where corporate bonds are both stressed and illiquid.

I believe that SLF-MF does not solve the real problem at all, because mutual funds by their very design need to liquidate assets to meet redemption. Unlike banks and hedge funds, mutual funds are not designed to use leverage: the Securities and Exchange Board of India (SEBI) Mutual Fund Regulations state:

The mutual fund shall not borrow except to meet temporary liquidity needs of the mutual funds for the purpose of repurchase, redemption of units or payment of interest or dividend to the unitholders:

Provided that the mutual fund shall not borrow more than 20 per cent of the net asset of the scheme and the duration of such a borrowing shall not exceed a period of six months.

Some mutual funds do talk and act as if the 20% limit allows them to borrow to juice up their returns or to speculate on prices rising in future. But the regulations are clear that this is not the intention, and any mutual fund that borrows for such speculative purposes is actually running a hedge fund in disguise. The proper use of borrowing is to deal with operational timing mismatches where a fund is not able to sell assets and realize the proceeds in time to meet the redemption needs.

Back in 2008, when the RBI launched a facility similar to SLF-MF during the Global Financial Crisis, I explained why mutual funds cannot borrow their way out of redemption trouble:

A mutual fund is very different from a bank. When a bank borrows to repay depositors, there is a capital cushion that can take losses on the assets side. When this capital is gone, the bank also needs to be recapitalized and cannot solve its problems by borrowing from the central bank. A mutual fund does not have any capital separate from the unit holders. This means that the only prudent way for a mutual fund to repay unit holders is by selling assets. If it borrows, then it is exposing remaining unit holders to leveraged losses.

The problem that the mutual fund industry faces today is in many ways worse than in 2008. Until Covid-19, open end debt mutual funds could offer redemption on demand to their investors because there was a liquid market for the bonds that these funds held in their portfolio. Now, the assets have become illiquid and hard to value while the investors are still able to demand instant liquidity. This mismatch can be solved only by some combination of two things: (a) the liquidity of the assets could be improved by a market maker of last resort, or (b) redemption could be restricted. The SLF-MF does neither of these, and merely postpones the problem till the maturity date of the borrowing.

Any financial crisis is ultimately resolved by allocating and absorbing losses. Everything else is a stopgap arrangement that merely postpones the day of reckoning. In times of crisis, there is sometimes merit in such postponement because it buys time for a more orderly loss allocation. But, whenever we kick the can down the road, we must ensure that by doing so we do not make matters worse in terms of making the losses bigger or making the ultimate loss allocation less fair or more difficult. The SLF-MF does not pass this test because it rewards those who redeem and penalizes those that remain in the fund (thereby incentivizing a run on all debt mutual funds):

What then are the solutions to the problems of the mutual fund industry today? I will first outline three solutions that I do not recommend:

My preferred solution is for the mutual fund industry itself to create the buyer of last resort with only limited support from the sovereign. It is guided by the principle that whenever we bail out the financial sector we do so not to help the financiers but to protect the real economy which depends on a well functioning financial sector. In these troubled times, the real economy cannot afford the loss of any source of funding. This is the same principle that guided my proposal earlier this month for a preemptive recapitalization of banks and non bank finance companies.

My proposal is similar to the US Fed’s Secondary Market Corporate Credit Facility mentioned above with one critical difference. Instead of the equity for the SPV coming from the government, it should come from the mutual funds themselves. When investors redeem from a mutual fund, and the fund is not able to sell bonds in the market, it can sell the bonds to the SPV at a fair value as determined by the SPV. The mutual fund will be required to contribute a percentage of the fair value as equity stake in the SPV and will receive only the balance in cash. If we follow the US and require 10% equity for the SPV, then a mutual fund selling bonds with a fair value of 100,000 to the SPV will have to contribute 10,000 towards the equity of the SPV. The SPV will use the equity of 10,000 to support 90,000 of borrowing from the RBI which allows it to pay 90,000 as the cash component of the purchase price to the mutual fund. The equity contribution of the mutual fund to the SPV has to come from the investors of the mutual fund. So an investor redeeming 100,000 from the fund would get 90,000 in cash and get the remaining 10,000 in the form of units representing the equity stake in the SPV.

This means that a large part of the credit risk of the bond remains with the redeeming investors as a whole. If the SPV ultimately realizes only 96% of the fair value of all the bonds that it bought, then its equity will come down to 6% from the original 10%. The redeeming unit holder will have got (a) 90,000 in cash and (b) shares in the SPV worth 10,000 originally, but worth only 6,000 when the SPV is wound down. The redeeming investor ends up with 96% of the original fair value of the bonds which matches the 96% ultimate realized value of the bonds. On the other hand, if the SPV realizes 103% of the fair value, then the original equity rises to 13% and the redeeming investor recovers 103,000 (90,000 in cash plus shares in the SPV worth 13,000).

Let me discuss some possible objections to the proposal:

Finally the proposal reflects a realistic evaluation of the current situation:

Posted at 19:09 on Tue, 28 Apr 2020     View/Post Comments (1)     permanent link