Marking debt instrument to markets

Sebi’s new norms will lead to volatility in debt fund market

There are three types of investors in mutual funds, who gain or lose based on the daily Net Asset Value (NAV) - one, those who come in; second, those who stay put in the fund; third, who exit the fund. It is pertinent to ensure the NAV declared is fair to all of them.

NAV would be ‘fair’ to all only if it reflects realisable value of a unit. In other words, the portfolio, if sold, should realise the market value that is equivalent to an aggregate value of all the outstanding units. Calculation of this ‘fair’ value of a unit is very simple if we have a market value for each portfolio asset, that is, security or stock. This practice is popularly known as marked-to-market (MTM).

In the Indian equity market, the secondary market is broad-based, liquid and vibrant. Hence, valuing a unit at marketor fair price is simple in equity funds. The secondary market in debt space in India, on the other hand, is still wholesale and relatively less liquid. A lot of debt and money market securities are not traded for days. Commercial Papers (CPs) and Certificates of Deposits (CDs) are not listed on the exchange and hence, not MTM. In the absence of a market price for such securities, it remains a challenge to derive realisable value of the underlying securities and hence the units.

The risk, therefore, in the current scenario is that while the units are priced based on the amortised value of portfolio securities. The latter, if required to be sold, might fetch more or less than the assumed or amortisation value.

In both the cases, one type of investor will be benefiting at the cost of others.

# If short-term interest rates go up, the units remain overvalued, as they are not valued at realisable price. Hence, the exiting investors leave behind their share of loss to remaining investors. This is what we saw in the 2008 liquidity crisis.

# If short-term interest rates go down, the units remain undervalued, as they are not valued at realisable price. Hence, the new investors benefit, unduly as they effectively get undervalued units.

To address this potential for under or over valuation of units of funds other than liquid funds due to the current practice of money market securities, the Securities and Exchange Board of India (Sebi) has mandated new valuation guidelines.

As a result of these new valuation norms, the NAV of funds other than liquid funds would not be linear any more and could fluctuate. The NAVs would depend on the portfolio yield and the efficiency of the fund manager to manage duration. Liquid funds, on the other hand, can buy securities with residual maturity up to 91 days; hence, would continue to give near-linear returns.

The disadvantage, however, in moving to liquid funds is the tax disadvantage. Dividend Distribution Tax (DDT) in ultra short-term bond funds is 13.84 per cent and 22.145 per cent for individuals and non-individuals, respectively, whereas a liquid fund attracts DDT of 27.68 per cent for all.

Mutual funds remain one of the most transparent financial investment for investors and these changes, applicable from August 1, will be yet another step in the same direction.

The writer is head (products) at Birla SunLife Asset Management Company. The views expressed are personal.