NAVs of long-term gilt and medium-term debt funds crash

After the gradual inching up of interest rates that was chiseling away returns from debt and gilt funds, it is time for the deluge. The Reserve Bank of India's (RBI) knee-jerk reaction to cease speculation in the forex markets has led to a crash in net asset values of long-term gilt and medium-term debt funds.

The central bank, on Friday, had hiked the cash reserve ratio or CRR by 50 basis points to 8.5 per cent while the bank rate was increased by 100 basis points to 8 per cent. Interest rates and bond prices move in opposite direction. Thus, when interest rates move up, bond prices move down and vice versa. The impact is more on long-dated securities. The unexpected tightening of liquidity saw government securities plummet by as much as Rs 2 on Friday.

The selling pressure in the government securities market continued on Monday as investors sold gilts to cut further losses. "We are witnessing an across-the-board selling pressure as banks have joined the selling spree. The fall is much sharper than Friday. Investors just want to generate cash and stay on the sidelines till the market stabilises," says the debt fund manager of a Bombay-based, bank sponsored mutual fund.

"We liquidated a large part of our debt holdings on Friday itself to reduce losses. With the RBI reducing the refinance limits, it seems this is a medium-term move and we would like to remain at the short-end of the market," adds Akhilesh Gupta at Dundee Mutual Fund. The gilt fund from Dundee Mutual lost around 13 paise on Friday with the NAV falling from Rs 11.25 to Rs 11.12.

Mutual fund sources say mutual funds have also heavily sold their holdings of government securities. "As of now, there has been no redemption pressure on gilt and debt funds but fund managers do see some redemption coming in the next two-three days. Apart from fears of redemption pressure, call rates are expected to go up, as liquidity gets tighter. Thus, funds are looking to compensate a part of their losses during the recent mayhem by deploying money in call markets," says a debt analyst at a private mutual fund.

In fact, a number of mutual funds are believed to be aggressively communicating to their investors, especially big-ticket ones, that they should not panic and redeem their units. For instance, Templeton Asset Management Company has drawn a leaf out of similar events in 1998, which led to a sudden hike in interest rates on January 16, 1998. Drawing a comparison, Templeton has stated that though the interest rate hike had an impact on the returns of investors who entered prior to January 16, 1998, "Those investors who stayed with the fund could average out their return and get back to normal returns over the next three months."

"This clearly illustrates that once the effect of the shock settles down, the returns potentially improve and we do believe that this is the time to take advantage of rate increase and rather than redeeming, an investor should make some investments," it further adds. Birla Mutual and Kotak Mutual have also issued similar notes on the impact of RBI's announcements and have advised investors to stay invested rather than redeeming their units.

The worst hit in the recent carnage in money markets has been the long-term gilt fund from Alliance Capital. The fund, which had an average maturity profile of 6.5 years as on June 30, 2000, has lost a whopping 1.81 per cent in just a day with its NAV plummeting from Rs 1088.80 on July 20 to Rs 1069.06 on July 21. Birla Gilt Plus (Investment), which had two government bonds maturing in 2008 and 2009 has also lost 1.44 per cent, with its NAV sliding by 15 paise to Rs 10.75.

These funds will see further erosion in their NAVs if they were not able to exit from their long-term gilt holdings on Friday. The category of long-term gilt funds, with 23 funds, has lost an average 0.81 per cent. The gilt fund from LIC Mutual fund has been the least hit, with the fund losing just a paisa. It seems the fund was at the short-end of the market and has weathered the turbulence in the market.

Among medium-term debt funds, Alliance Liquid Income has suffered the maximum casualty, with the NAV dropping by 10 paise or 0.67 per cent to Rs 14.83. The fund had a 50 per cent exposure to government securities as on June 30, 2000. Among other debt funds with a high gilt exposure, Templeton India Income Fund has seen its NAV go down by 7 paise to Rs 15.35. The fund had a 30 per cent exposure to gilts as on June 30, 2000.

However, the full-blown effect of RBI's measures on medium-term debt funds will be reflected only as AMCs re-align the yields on their corporate debentures. A few of the debt funds, with marginal or nil exposure to government securities have gained on Friday. "There is always a time lag between gilt and corporate bond markets since very few corporate bonds are traded in the secondary market. While the NAVs of our public sector and corporate bond funds gained marginally on Friday, these funds have lost today after we marked-to-market our portfolio, reflecting the current yields," says Akhilesh Gupta at Dundee Mutual Fund.

In fact, the current slump in the debt markets has once again brought to the fore the issue of valuation of corporate debt instruments. It may be recalled in the aftermath of the hike in interest rates on January 16, 2000, a few debt funds had not shown a fall in their NAVs since they did not mark-to-market their portfolios. "This issue is very likely to come up now as the regulators have failed to devise a standard valuation model so far, which is to be adhered to by all AMCs while valuing their illiquid or seldom traded debentures," says the marketing head of a mutual fund.

THE DAY AFTER

Fund	NAV on July 20, 2000 (Rs)	NAV on July 21, 2000 (Rs)	Change (%)
Alliance GSF (LT G)	1088.80	1069.06	-1.81
Birla Gilt Plus (Inv) (G)	10.90	10.75	-1.44
K Gilt Serial - 2007	11.09	10.94	-1.33
Templeton IGSF (G)	11.70	11.56	-1.23
Tata GSF (A)	11.44	11.31	-1.14
Dundee Sovereign Trust (HY)	11.25	11.12	-1.12
Dundee Sovereign Trust (DQ)	11.28	11.15	-1.11
Dundee Sovereign Trust (G)	11.43	11.30	-1.11
Dundee Sovereign Trust (DM)	11.22	11.10	-1.11

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