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US-64: Keep it assured

Haseeb A Drabu

In 1998, when it was first discovered that the Unit Trust of India had negative reserves, the Reserve Bank of India swung into action and bailed out UTI by giving it line of credit.

This came as a surprise especially since the finance ministry had not asked the RBI to intervene. But the logic of RBI's action was simple: if UTI dumped its stock of government paper, it would cause havoc in a market that the RBI was responsible for. So, UTI was bailed out not for UTI's sake but for the sake of the debt market.

In the current bail-out package, apart from protecting the investors in US-64, the larger logic is to prevent US-64 (and UTI) from indulging in distress sales which is in the interest of a wider class of investors. But a closer look at the package suggests that it cannot prevent the UTI from selling.

Through the bailout package the government will make good the shortfall in the scheme. For simplicity, if we assume that all units had to be redeemed at Rs 10 in May 2003 and that the NAV is around Rs 6 at that time, the government will put in Rs 4. Even then, UTI will have to look for ways to bring in the cash of Rs 6 to redeem units when unit-holders queue up to encash their units.

How else can UTI do this, if not by selling securities from its portfolio in the market? UTI is committed to running US-64 as a balanced scheme. So it can't sell off the government securities in its portfolio to release cash.

If it does, the scheme's asset allocation gets disturbed. Indeed, a relatively higher equity level has been identified as one of the main culprits of the mess that both US 64 and other assured return schemes find themselves in. So, UTI will continue to be a seller in the market and a fair share of equities will be on the block.

To prevent UTI from selling and dampening the equity markets, the government will have to devise a package that persuades investors to hold on to their US-64 units. And there is only one way they can do so: let the scheme remain an assured return product. Active investors will not be happy staying put with the fund if it loses its character as a regular return product.

There are several balanced funds in the country that have excellent track records. So why would anyone stay with UTI, if he wants a pure mutual fund product?

Since the scheme opened for sale this year, it has collected less than Rs 100 crore (Rs 1 billion), underlining the fact that there is little appetite for such a product. Also, a large chunk of investments in US-64 come from charitable trusts, pension funds and corporates, all of whom look for tax-efficient guaranteed returns.

This, however, does not imply that, in the effort to retain its earlier character, US-64 will have to offer returns that are completely out of sync with the market. But the scheme should definitely stand out as the most tax-efficient assured return product in the market.

This can be done by issuing tax-free government bonds (that are a shade above that offered by RBI relief bonds) in lieu of US-64 units.

These bonds can be offered to the lenders as well. If they are unwilling, the scheme could be kept open for sale till it collects about Rs 5,000 crore (Rs 50 billion), to repay the lenders. This will mean US-64 will then be a balanced scheme offering fixed returns. Ideally, such a bond should be closed-ended with a lock-in period of, say five to seven years.

The entire portfolio of US-64 can then be retained and the scheme will not have to resort to forced sales. Shares can be sold only when they receive the right price.

Meanwhile, UTI can continue to aggressively pursue strategic sales to realise good, and even exceptional value from its investments. If liquidity is the issue, it can be provided through secondary market with the condition that the tax-free status will be lost if the security is transferred.

Since the government is taking a risk by acquiring equity assets and compensating investors by way of fixed returns, returns earned in the scheme in excess of the required level should also be funnelled back to the exchequer - not the bondholders.

The idea of giving fixed returns on a equity heavy portfolio may sound absurd but it is not. Especially when there is a compelling reason to invest in equities rather than debt as is the case right now.

At a price-earning multiple of 13 (on a trailing basis) for the Sensex, the earnings yield works out to 7.69 per cent. It'll be much higher on a forward basis. In contrast, the yield on five-year government paper is 6.39 per cent. So, the argument is clearly in favour of equities.

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