Debt funds faced redemptions worth over Rs 1.94 trillion in March. The largest outflow of over Rs 1.1 trillion was from the liquid fund category because companies pulled out cash to cope with lockdown pressure. Instead of selling securities at deep discounts in a bearish market, funds opted to meet redemption by borrowing from banks. As a result, many schemes are reporting net liabilities in terms of assets by end-March. Debt funds remain under the gun in April as well because redemption pressure has continued. While the Securities and Exchange Board of India allows debt funds to borrow up to 20 per cent of assets under management (AUM) to meet redemption demands, borrowings could easily cascade beyond that level. Some schemes had already borrowed over 17 per cent of AUMs to meet redemption demands by March-end. Despite surplus liquidity, yields on corporate debt have shot up. The risk is that the debt market remains braced for a significant increase in government borrowing, which will suck up resources and leave little for companies.
Lenders are also apprehensive about the impact of an extended lockdown on the economy. If commercial debt rates continue to rule high, many debt funds would be in serious trouble. The danger is that this stress could translate into trouble for the corporate sector, which needs to tap debt mutual funds for short-term funding. The Rs 6-trillion short-term debt market includes a large component of commercial papers issued by companies, and certificates of deposit issued by banks and financial institutions. This is a key arena for debt mutual funds to deploy cash. If the debt mutual segment is cash-strapped due to redemption stress, companies will also be starved of liquidity just when they need it most. Therefore, the central bank must prepare to act as the lender of the last resort in this market. The RBI did open a facility in 2008 and 2013. In both the cases, the RBI held special auctions and accepted short-term debt securities as collateral from banks, which were then allowed to lend to mutual funds. On both occasions, the special facility helped ease pressure. However, things are more uncertain this time. The markets would perhaps need some sense of normalisation and the amount of government borrowing. Extending the lockdown or extremely slow economic recovery will increase credit risk. Thus, the government and regulators will need to come up with more creative measures to contain the pressure in the debt market. Pumping cash into the system alone will not help.
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