Liquid mutual funds are mainly used by investors to park money for very short periods of time ranging from a few days to few months for earning returns that are significantly higher than savings bank interest rates and at the same time having adequate assurance of capital safety. As the name suggests, these debt mutual fund schemes are highly liquid and are considered to be one of the safest investments. However, several cases of defaults and credit rating downgrades of debt and money market securities over the last 9 – 10 months have dented investor confidence in debt mutual funds. Even some liquid funds were affected by these credit risk related episodes. Over the past few months, the capital market regulator SEBI has introduced several regulatory changes in liquid funds to make these investments more transparent and also protect interests of investors. In this blog post, we will discuss some of the regulatory changes with respect to liquid funds and how it will benefit investors.
Mark to market versus amortization
Liquid funds invest in money market or debt market securities which have residual maturities of less than 90 days. The usual Net Asset Value (NAV) valuation practice in liquid funds was amortizing the difference between the purchase price and maturity value of the residual maturity of a security. For example, if the purchase price of a security today is Rs 95 and the maturity value after 60 days is Rs 100, then as per the amortization method, the price of the security will increase linearly from Rs 95 to Rs 100 over the next 60 days. Day to day market movements had no impact on market movements. The amortization method was used for valuing all debt securities maturing within 60 days. Only securities which were maturing after 60 days or more were marked to market based on market based valuations given by the two SEBI designated valuation agencies, CRISIL and ICRA.
Problem with amortization method
As described earlier, in the amortization method, the price movement is almost linear and therefore, very stable. While low volatility is certainly desirable for investors, the problem with this method is that, it ignores deterioration in the financial situation of issuers and their ability to pay the maturity value. If credit rating of the issuer gets downgraded, then average investors will be in the dark about the true value of their investment because they will be seeing steady growth in NAV on a daily basis in the amortization method which is obviously misleading.
Change from amortization to marked to market method
To bring more transparency in NAVs of debt mutual funds, especially liquid funds, SEBI changed the valuation methodology from “amortization” to “mark to market”. This was done in two phases. A few months back SEBI made it mandatory for Asset Management Companies (AMCs) to mark to market all securities maturing after 30 days.
What is mark to market? CRISIL and ICRA provide market-based valuation level given by the valuation agencies, every day, for all securities in the portfolio of mutual funds. For purposes of NAV calculation, AMCs will have to use market valuations instead of the amortization. In a recent regulatory change, SEBI did away with the 30 day mark to market exemption and made it mandatory for all securities (irrespective of residual maturities) to be marked to market.
How will this regulatory change benefit investors?
On the face of it, this regulatory change will make liquid mutual funds slightly more volatile. But despite higher daily volatility, it will be beneficial for investors because on any given day the investor will know the true value of his or her investment in the scheme. In amortization method, the NAV would keep increasing even if the true value of the underlying security was impacted by credit risk, misleading the average investor. Eventually the scheme would have had taken a bigger mark down from the artificially inflated NAV.
Suggested reading: Understanding credit risk
With more transparency in daily NAVs, investors will be able to make informed decisions of whether to remain invested or redeem or switch to a different scheme. Though the incremental impact on volatility of liquid mutual funds on account of mark to market valuation, in our view, will be quite small, investors who have extremely low tolerance for volatility or have extremely short investment horizon e.g. just a few days, can opt for overnight funds.
Some other regulatory changes
SEBI had announced some other changes to make liquid funds safer for investors. Some of these are:-
- At least, 20% of the assets under management of liquid funds will be held in risk-free instruments like Government Securities, Treasury Bills and cash
- Maximum exposure in a single sector has been reduced from 25% to a cap of 20%
- The additional exposure of 15 per cent to Housing Finance Companies has been reduced to 10% in Housing Finance Companies and 5 per cent in securitised debt based on retail housing loan and affordable housing portfolios
In this blog post, we discussed SEBI’s recent regulatory changes with respect to liquid mutual funds. These changes will make liquid funds more transparent and safer for ordinary investors. These changes will also enable investors to make more informed investment decisions based on their investment needs. Liquid funds continue to be safe and great investment options for parking your short term investment needs. You should consult with your financial advisors if liquid funds are suitable for your individual investment needs.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.