New valuation norm will enhance transparency of liquid funds portfolio

The 30-day mark-to-market rule could make them volatile and reduce returns

The Securities and Exchange Board of India (Sebi) has stipulated that all debt papers with a maturity of 30 days or more held in liquid fund portfolios will now have to be marked to market. Earlier, fund houses had to do so only for papers having a maturity of 60 days or more. 

In September 2018, rating agency Icra had downgraded the debt papers of IL&FS and its subsidiaries by multiple notches to default grade within a short period. The net asset values (NAVs) of many debt funds, including liquid funds, had declined sharply by over 1 per cent within a day (they fell more later). "The big fall in NAVs within a single day after the IL&FS default provided the trigger for this change of rule by Sebi," says Pankaj Pathak, fund manager–fixed income, Quantum Mutual Fund. 

Earlier, 60 days and above papers followed the accrual method of valuation, which works as follows. Suppose that a fund manager buys a paper at Rs 97 and will get Rs 100 at maturity. Under this method, the Rs 3 he earns in interest is divided over the paper’s tenure and is added daily to the NAV. This valuation approach is not concerned with the paper’s secondary market price, and there could be a wide divergence between the two. 

Liquid funds have often been sold by touting high past returns. Fund managers invested in lower-quality papers to earn higher returns. “The 60-day rule helped mask the credit risk in poorer-quality papers,” says Gautam Kalia, head–investment products, Sharekhan by BNP Paribas. Even if there was volatility in the price of such papers, as the market perceived them to be risky, it did not get reflected in the fund’s NAV. Now, the scope for such masking has got reduced. 

In future, the probability of liquid funds taking large hits to their NAVs within a short period will also lessen, as their NAVs will already be closely aligned to market valuations. “Sebi’s move will enhance transparency of liquid funds,” says Mahendra Jajoo, head of fixed income, Mirae Asset Global Investments. 

There could be a couple of negative fallouts, too. One, the NAVs of these funds could become volatile. Pathak, however, says that investors should not be excessively concerned about this. “In the money-market, volatility is not high usually. It only spikes when there is a sharp change in an issuer’s credit profile. Otherwise, it mostly stays within the tolerable band,” he says. 

Two, returns of liquid funds could come down slightly. “If fund managers continue to invest in low-quality papers, then the NAVs of their funds will be volatile. Investors, especially the institutional ones, do not like volatility in liquid funds since they park money in them for short durations. Fund managers will be forced to move to higher-quality papers, and this could bring their returns down,” says Kalia. 

Give priority to safety and liquidity over returns when investing in liquid funds. Do not chase funds that have fetched the highest returns in the past. “Since their duration profile is capped by regulation, the only way fund managers can add to returns is by taking higher credit risk,” says Pathak. Instead, examine the fund’s portfolio. According to Pathak, funds that invest more in treasury bills and papers issued by quality public-sector units would be a safer bet. Jajoo suggests that the ratings of the bulk of the portfolio should be AAA and AA+, and it should hold strong and well-known entities. Kalia adds that if an AMC has invested in corporate debt, then not just the short-term ratings but the longer-term ratings of papers from those entities should also be high.