Prof. Jayanth R. Varma’s Financial Markets Blog

Mutual fund redemptions redux


Debt mutual funds are not banks: when mutual fund investors redeem their units at an inflated Net Asset Value (NAV) they simply steal money from their co-investors. This adjacency risk or co-investor risk comes to the fore every now and then, when heightened default risk makes bond prices volatile and unreliable. This happened in India in 2008 during the global financial crisis and is happening again today. Providing liquidity to solvent banks in a crisis makes sense, but providing liquidity to debt mutual funds is a bad idea because it simply allows rich, better informed investors to steal from less informed co-investors. The correct way to provide liquidity is to lend not to the mutual fund but to the unit holder (against units of debt mutual funds).

Unfortunately, I appear to be in a minority on this issue. Even the best analysts appear to support liquidity lines for the mutual fund; for example, the highly knowledgeable and respected Akash Prakash writes in today’s Business Standard (paywall):

Liquidity lines and repo facilities have to be set up for the debt mutual funds. We cannot allow forced selling at panic prices. Panic selling will force other funds to also mark down their bonds, showing paper losses, creating more redemptions, more selling and we will spiral into a negative feedback loop.

My position is the opposite: we must force mutual funds to mark down their bonds so that their NAVs are fair and correct. The way to stop panic selling is side pockets and gates as I have been saying for the last ten years: during the 2008 crisis in India (borrowing and gating), during the Amtek Auto episode, and in response to US money market mutual fund reforms (minimum balance at risk and gates).

Liquidity lines to the mutual funds are a bail out of rich corporations and high net worth individuals at the cost of the ordinary investor. Liquidity lines to unit holders (against the security of units of debt mutual funds) do not have this problem because then the bond price risk remains with the borrower and is not transferred to other co-investors.