Case 066Liquidity, redemptions and stressHard

A debt scheme of Kaveriya Mutual Fund needs Rs 120 crore for redemptions. It can borrow for up to six months at 8.5% (within the regulatory borrowing limit; confirm the current figure) or sell a 7.8% bond now at a 60 basis point discount to fair value. Which is cheaper for remaining investors, and when does borrowing become the worse choice?

The situation

Kaveriya Mutual Fund's Rs 1,500 crore corporate bond scheme faces Rs 120 crore of redemptions after a credit scare elsewhere in the market. Its liquid assets are already committed, so it must either borrow or sell bonds.

Option one: borrow from a bank at 8.5% a year for up to six months, which SEBI's rules allow for meeting redemptions up to a limit; confirm the current limit and conditions. Option two: sell Rs 120 crore of a 7.8% bond today, where the only bids are 60 basis points below the bond's fair value. Dealers expect the market to calm within three months, but they cannot promise it. The fund manager wants a recommendation by the afternoon.

Your task

Which route costs the remaining investors less, how long can borrowing stay cheaper, and in what situation does it become the worse choice?

Quick check

Borrowing at 8.5% to avoid selling a 7.8% bond: what does it cost each month?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Borrowing is cheaper while the stress is temporary: Rs 0.21 crore for three months, or Rs 0.42 crore for six, against Rs 0.72 crore to sell today. Selling would only win after 10.3 months of borrowing, beyond the limit. Borrowing becomes the worse choice if the stress outlasts the loan: the fund pays the carry and then sells at a wider discount, about Rs 2.22 crore. If that has more than a 25% chance, sell now.

Step 1What does each route actually cost?

Imagine needing cash for a month and owning a gold chain. You can pawn it and pay interest, or sell it today to a dealer offering less than it is worth. Pawning is cheaper if you are sure you can redeem it soon. Selling the bond costs a one-off 60 basis points; borrowing costs the gap between the loan rate and what the kept bond earns, for as long as the loan runs. Selling: 0.6% of Rs 120 crore is Rs 0.72 crore, paid today by the remaining investors. Borrowing: 8.5% minus 7.8% is a negative carryThe cost of holding a position whose financing rate is higher than the income it earns. of 0.7% a year, Rs 0.07 crore a month.

So three months of borrowing costs Rs 0.21 crore and six months Rs 0.42 crore, both below Rs 0.72 crore. The two costs meet at 0.6 divided by 0.7, times 12: 10.3 months. Inside the six-month limit, borrowing always beats selling on carry alone. That is the easy half of the answer.

Raising Rs 120 crore by selling now costs Rs 0.72 crore, borrowing for three or six months costs Rs 0.21 or Rs 0.42 crore, but borrowing for six months and then being forced to sell at a 1.5% discount costs Rs 2.22 crore.

Step 2When does borrowing become the worse choice?

When the stress does not pass. A loan must be repaid, and if redemptions keep coming or the market stays shut, the fund ends up selling the bond anyway, later, into a worse market. Suppose the discount widens to 1.5% by then. The fund has then paid six months of carry and a larger discount: Rs 0.42 plus Rs 1.80 crore, about Rs 2.22 crore, three times the cost of selling today. Borrowing is a bet that today's stress is temporary.

The cost of borrowing rises Rs 0.07 crore a month and would only overtake the Rs 0.72 crore cost of selling after 10.3 months, beyond the six-month limit, but if the stress lasts and the bond is sold later at 1.5% below fair value the total reaches Rs 2.22 crore.

Put a probability on it. If the stress passes within three months, borrowing costs Rs 0.21 crore; if it persists, about Rs 2.22 crore. Borrowing and selling cost the same when the chance of persistence is (0.72 - 0.21) divided by (2.22 - 0.21), about 25%. At a 30% chance, borrowing's expected cost is Rs 0.81 crore, already above selling. The decision turns on one judgement: is the chance that this stress lasts six months below about a quarter?

Step 3What else should decide it?

Three things beyond the arithmetic. First, who is redeeming. If the Rs 120 crore is one or two large investors, the outflow is a one-off and borrowing is attractive; if it is broad, panicky selling, more will follow and borrowing only delays the sale. Second, what borrowing does to the investors who stay. Rs 120 crore is 8% of the scheme, so the remaining investors carry leverage they did not choose, and if the bond's price falls further, they bear all of it. Third, the limit itself: a fund that borrows near its ceiling has no room left if a second wave arrives.

So the recommendation is conditional and can be said in one line: borrow if the outflow looks concentrated and the market is likely to reopen within weeks, and sell now, preferably a slice across holdings, if the outflow is broad. Tell the trustees either way, because borrowing to meet redemptions is a decision they should see.

Where candidates lose it

Candidates compare the 8.5% loan rate with the 0.6% discount and conclude borrowing is far more expensive. The bond is kept and keeps earning 7.8%, so the real cost of borrowing is only the 0.7% gap.

The opposite miss is stopping at the carry and calling borrowing obviously cheaper. The loan must be repaid, and if the stress lasts, the fund sells anyway at a worse price. The case is about that conditional, not the carry.

What the interviewer asks next

The redemptions come from a single treasury that tells you it will reinvest in two months. Does that change the answer?
How would you sell Rs 120 crore if you chose to sell: one bond, or a slice across the portfolio?
What should the fund disclose to investors when it borrows to meet redemptions?

Company names and figures are illustrative.