The Hindu Business Line : US-64 Bonds: Do the holders deserve a bonus?

What a difference five years can make in the world of investments! In June 2003, when investors in the Unit Scheme 64 were allowed to swap their units in the beleaguered mutual fund for bonds, they would have heaved a collective sigh of relief.

With the US-64’s equity portfolio in a battered state due to a moribund stock market, the bonds offered a safe haven — a tax-free return of 6.75 per cent, backed by sovereign guarantee, never mind that they had kissed good-bye to anything between 30-50 per cent — depending on the time of purchase — of their original investment. When the government issued these bonds and assumed ownership of the scheme’s equity portfolio through a special vehicle, it did so as a bail-out measure to investors in India’s largest mutual fund scheme.

But now, as the US-64 bonds come up for redemption in end-May, original investors in US-64 have reason to rue their decision to opt for bonds in place of equity! The government, on its part, has reaped an unexpected bonanza from its “bail-out” decision. It is set to reap sizeable gains, after meeting its repayment obligations on the bonds, from the scheme’s now-rejuvenated portfolio.

Sizeable gains

Over the past five years, the 6.75 per cent returns offered by the US-64 bonds have been easily eclipsed by the spectacular stock market returns. A breathless rally in stocks has seen the BSE Sensex rise five-fold (from 3200 to 16500 points).

Balanced funds, which have portfolios similar to the erstwhile US-64, have delivered returns of 25-30 per cent annualised, over this five-year period. All this has led to sizeable gains on the portfolio of the US-64 managed by the special vehicle, and now owned by the government.

Special Undertaking of Unit Trust of India, or SUUTI — which inherited a portfolio of government bonds, equity stake in listed and unlisted companies and some prime property, has over the years disposed of stakes in several of the illiquid assets and property through a combination of open market and strategic sell-offs. By March 2007, the original portfolio of about Rs 17,000 crore vested with SUUTI had nearly doubled in value to Rs 31,000 crore, leaving a substantial surplus over its redemption liabilities of about Rs 15,000 crore.

As on date, SUUTI continues to retain some of its larger equity stakes in bluechips such as L&T, Axis Bank and ITC. Such has been the appreciation in the value of these stocks that today, the entire redemption proceeds of Rs 8,000 crore for the US-64 bonds, can be met by the sale of just one holding. The fund’s 27 per cent stake in Axis Bank alone is worth Rs 7,800 crore at today’s market prices.

Risk rewarded?

With the special vehicle set to deliver a sizeable and unexpected profit, should these profits be pocketed entirely by the government? Seen purely from an investment standpoint, this can be justified. When it comes to investing, it is the risk-taker who always gets the higher reward.

It can be argued that the government assumed all the risks attached to US-64’s equity portfolio in 2003 and thus is being rewarded for this. US-64 investors, on the other hand, swapped their risky units for safe bonds, and thus have to forego the rewards of equity investing.

Hobson’s choice

But to take the above line of argument is to ignore the circumstances under which US-64 investors made their decision to opt for bonds in June 2003. Theirs was nothing but a Hobson’s choice. Consider the circumstances surrounding the bond offer.

Despite ominous signals in the preceding years, US-64’s troubles were officially made public only in July 2001, when the fund abruptly and unilaterally shut the exit window to unit-holders, citing problems in meeting redemptions. The fund’s NAV, about which investors were kept in the dark until much later, had plunged well below Rs 10 because the fund had continued to pay dividends and meet repurchase obligations out of its capital for years, despite a steadily eroding equity portfolio.

Even when the fund re-opened its repurchase window at ‘assured prices’ of over Rs 10 a couple of months after this ‘freeze’, this was only for investors who held up to 3,000 units (later enhanced to 5,000) in the scheme.

Large unit-holders in the fund, therefore, had no opportunity to exit the fund at a fair price, once the crisis came to light. The offer to swap remaining units into the 6.75 per cent bonds came only in June 2003, two years after the crisis broke, and after UTI had already been broken up into two entities, preparatory to being wound down.

The fund was all along marketed as a regular dividend-paying scheme, when in reality, its portfolio structure (invested to extent of 60-70 per cent in stocks) relied heavily on stock market conditions for returns.

As the fund didn’t disclose its NAV (about Rs 5.8 per unit when it was first revealed) until after the troubles came to light, unitholders also had no clue about the real value of the assets managed by the scheme when they made their investments.

They had only the past record of repurchase prices set very close to the sale price for reference.They bought into the fund, not at NAV-based prices, but at a fixed sale price, which ranged anywhere between Rs 13.50 and Rs 15.80 per unit in the five years preceding the crisis. Therefore, bail-out notwithstanding, a major portion of US-64 investors would have suffered a significant capital erosion on their decision to exit from the scheme.

Redemption bonus

It is in light of the above circumstances that it would be equitable for the government to share profits on the US-64 portfolio with original investors in the fund.

To ensure no loss to the exchequer, the government can deduct the original cost of the bail-out package, and retain enough to make up for the time value of money and apportion any remaining surplus among investors in the fund.

To ensure that only original investors in US-64 (and not the ones who acquired bonds in the secondary market) benefit from such a bonus, it can be distributed only to investors who were on US-64’s books on the original record date in June 2003.

That may compensate the nearly 13 lakh investors in US-64 bonds for some of the losses suffered on their investments in India’s oldest mutual fund scheme, through no direct fault of their own.

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