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Sebi's new rules have made liquid mutual funds safer. Here's how

Sebi has proposed changes that will ensure liquid funds stick to their mandate of utmost safety and liquidity.

, ET Bureau|
Updated: Jul 08, 2019, 02.10 PM IST
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The earlier practice where certain instruments were valued based on amortisation has been done away with.
The current debt market stress has not spared even a relatively safe avenue like liquid funds. Chasing higher returns, a few liquid funds invested in risky bonds. Despite being stray instances, the episodes took the sheen off these funds and alarmed the watchdog enough to step in. Sebi has now introduced a slew of measures to ensure liquid fund portfolios truly reflect the safety and liquidity that define this space.

The biggest proposed change pertains to the way liquid funds value underlying securities. The valuation of all instruments will now be entirely on mark-to-market basis. This means all securities in the portfolio will be valued at prevailing market price.

The earlier practice where certain instruments were valued based on amortisation has been done away with. Till some time back, only bonds maturing after 60 days were valued at market price. For bonds with lower maturity, the difference between the purchase and redemption prices on maturity could be amortised or spread over the tenure of the instrument. This was recently changed to include bonds maturing after 30 days.

However, this often gave a distorted picture when credit events hit any underlying security. Since the value of all instruments amortised in this manner increases every day, any deterioration in a troubled bond’s value does not reflect in the NAV immediately. This artificially limits the volatility in the fund’s return and prevents the fund’s NAV from accurately reflecting the realisable value of its portfolio.

But introducing MTM on the entire portfolio will now make liquid funds more transparent, say experts. Kaustubh Belapurkar, Director-Fund Research, Morningstar Investment Advisor, argues, “With amortisation taken away, the NAV of liquid funds will now reflect the actual worth of the portfolio on any given day.”

Apart from this, liquid funds will now be required to hold at least 20% in liquid assets such as cash and cash equivalents like treasury bills and repo on government securities. This new norm is directed at ensuring sufficient liquidity at all times, particularly during periods of stress in the bond market when redemptions are high.

Arvind Chari, head fixed income and alternatives of Quantum Advisors, says, “Most prudently managed liquid funds were already maintaining high liquidity. This move will ensure all funds adhere to strict liquidity needs.” As of May-end, liquid funds on an average were holding 10% in liquid assets.

Further, liquid funds will henceforth introduce a graded exit load that will be levied on investors who exit the fund within seven days. This directive is aimed at minimising the impact of lumpy inflows and outflows. Institutional investors often park large surpluses in liquid funds and move out within a few days when better opportunities emerge. However, this money can leave smaller investors vulnerable. The graded exit load will level the playing field.

Says Belapurkar: “Much of this hot corporate money will now shift to overnight funds.” Overnight funds invest in securities with one day maturity, making them the least risky among debt funds. These are more suitable for corporate investors seeking instant liquidity.

Liquid funds have delivered healthy returns
The revised norms can impact the return profi le of the funds.
liquid-funds
Above list includes funds with corpus greater than Rs 15,000 crore. Source: Value Research. Data as on 2 July

Both liquid and overnight funds will no longer be permitted to invest in short-term deposits, debt and money market instruments having structured obligations or credit enhancements. Such an arrangement typically involves a promoter guarantee or offer of shares as collateral or loan against shares.

This practice came under the scanner recently after a few fund houses that gave loan against shares opted not to invoke the pledge or guarantee when the value of the collateral tumbled. This was perceived to be against the interest of investors as it limited the funds’ liquidity. Also, further tightening of sector caps for liquid funds—exposure to single sector will be limited to 20% as against 25% earlier—will reduce the concentration risk in these funds.

Clearly, these are all positive for liquid funds. Chari argues, “These measures will make liquid funds more liquid, diversified and a lot safer.” However, there is a downside to these revised norms. While these measures will enhance the safety and liquidity of these funds, they could also impact the return profile.

The need to keep 20% in cash or cash equivalents will reduce the overall yield from the fund portfolio while revised valuation norms will usher in an element of volatility in returns. “Investors will get a cleaner portfolio but will see dilution in returns and some added volatility,” says Belapurkar.

Even so, for investors looking to park their idle surplus productively, the makeover for liquid funds provides much needed comfort and makes them a better proposition. The majority of liquid funds continue to maintain highest quality, with diversified portfolios tilted in favour of AAA or equivalent rated securities. A few others have also cleaned up their portfolios.

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