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Business News/ Opinion / Online-views/  Mutual Funds | Liquid funds set to shed some more risk
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Mutual Funds | Liquid funds set to shed some more risk

Mutual Funds | Liquid funds set to shed some more risk

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What is the first thing you look for when you invest in a liquid fund? It’s safety, right? After the fiasco that liquid funds went through during the 2008 credit crisis, where many liquid schemes had to sell off their underlying holdings or securities at throwaway prices, the capital markets regulator, Securities and Exchange Board of India (Sebi), has not been taking any chances. Over the past three years, it has consistently reduced the risk levels that a liquid fund can take, while making their net asset values (NAVs) as realistic as possible. In fact, some experts claim that the Indian mutual fund’s (MF) debt fund regulations are on par—as far as risk contaminant is concerned—with those in many developed markets. After all, your funds’ underlying scrips must reflect their true worth.

Effective 30 September, your liquid fund will further de-risk itself. All holdings that mature beyond 60 days will be marked to market; these will, therefore, endure daily volatility. But this seemingly innocuous change is a part of a bigger change in Sebi’s mindset.

Rules-based to principles-based

As Shubho Roy, legal consultant at National Institute of Public Finance and Policy, and Ajay Shah, professor, National Institute of Public Finance and Policy, wrote in a blogpost titled Movement at Sebi towards principles-based regulation on Shah’s blog www.ajayshahblog.blogspot.com, in March soon after Sebi’s guidelines came out, statutory warnings on cigarette boxes are a good example of how rules-based guidelines can lead to companies finding loopholes and circumventing regulations. “The rules require that the font in which the statutory warning is printed should have a minimum ‘height’. Firms get around this by printing the warning in the required height, but reducing the width of the characters to a ridiculously low size, so that it is very difficult for readers to decipher. Thereby, they are able to comply with the directive for statutory warnings, yet defeat the purpose of warning buyers," write Roy and Shah.

As far as valuations of their holdings—be it equity or debt—are concerned, broadly, Sebi wants fund houses to adhere to the principle of fair valuation. While it’s easier to value equity securities because equity markets are liquid and a large segment of equity scrips are traded and, therefore, carry a market price, debt markets are a different ball game. They are illiquid and typically long-term bonds which don’t get traded daily. Up till now, Sebi had prescribed a detailed set of guidelines—they first came out in 2001 and later in 2002—to debt funds on how to value their underlying securities, depending on whether they are traded and also their maturity periods.

Now Sebi wants fund houses to value their debt securities the way they wish, but they must ensure that the scrips are valued as realistically as possible. The boards of the asset management company (AMC) and the trustees must approve the valuation policies. All fund houses must list their valuation policies on their websites.

“I think principles-based regulation is a good idea and we should move there. Rules-based regulation is just inviting a continual dog-fight between regulators and the industry, where the industry looks for loopholes. But at the same time, we have to see that principles-based regulation also requires commensurate modifications in the regulatory strategy. One, the burden of compliance with principles should fall on the top management and not on the compliance officer. Two, Sebi needs higher quality staff in order to enforce principles-based regulation. Three, we have to strengthen Securities Appellate Tribunal so that we have more capable judges disposing off a larger workflow," says Shah.

Valuing underlying securities

Crisil matrix: Because debt scrips are illiquid and many do not have a trading price, valuing them could be tricky. Credit rating agencies Crisil Ltd and Icra Ltd send matrices every day to all MFs. Every day, these agencies collate traded prices of all government securities (G-secs) across different “modified duration" and then give a suitable mark-up—in terms of yields—for other rated instruments. Expressed in years, modified duration tells you how much your debt fund would get affected if interest rates (a debt security’s or your bond fund’s yield) were to move up or down by 1%.

For instance, as on 25 July 2012, as per Crisil’s matrix, the G-sec yield for a scrip that comes with a modified duration of 0.25 and 0.5 years was 8.39%. As per this matrix, the mark-up for a AAA-rated security for a similar modified duration is 0.86%.

Graphic by Paras Jain; illustration by Jayachandran/Mint

On account of different types of debt securities, rating agencies now give several matrices daily to MFs. For instance, Crisil sends one matrix for traditional bonds, another one to measure the yields of bonds issued by non-banking finance companies and real estate companies, yet another one for short-term instruments and a few other for other types of instruments.

“The matrices are devised looking at trades that have taken place across trading platforms for benchmark securities using Crisil’s proprietary model. They seek to represent the indicative valuation levels for securities for a particular rating category and tenor.", says Jiju Vidyadharan, director, funds and fixed income Research, Crisil.

Discretionary mark-up and mark-down: Till June 2012, when the new Sebi guidelines came into force, debt funds were allowed some discretion to value their debt scrips. For instance, for securities that were rated by credit rating agencies of duration of up to two years, debt funds were allowed to provide a mark-up of 100 basis points (bps) on the upside and 50 bps on the downside. A basis point is one-hundredth of a percentage point. Since the new regulations are principles-based, discretionary mark-ups are now removed and the fund houses are free to use any mark-ups or mark-downs they want.

Here’s what this means. Say your debt fund bought an ABC company’s bond—a AAA-rated instrument—at a yield of 9.60%. Assume, on this day, the Crisil’s and Icra’s determined matrix yield for a AAA-rated instrument for a similar modified duration is a yield of 9.20%. This means, your debt fund has used a mark-up of 40 bps. Since the 40 bps mark-up was within the overall limit of 100 bps, this was allowed.

However, assume that on account of an unforeseen event, equity and debt market collapse; bond prices fall hard. Since bond prices and yield move in opposite directions, yields will shoot up. If your debt fund’s underlying bond gets downgraded in terms of its credit rating, its price falls and, correspondingly, it’s yield goes up. Assume, it’s yield goes up to 15% and your fund has to value it at the end of the day to determine its own NAV. Also assume, on that same day, the matrix determined yield for similar rated and equivalent duration bonds is 12%. If your debt fund were to have valued the ABC company’s bond at 15% (the prevailing market yield of that specific bond), that would have been a mark-up of 300 bps; a 100 bps mark-up would have allowed your debt fund to value this scrip at 13% at most.

Your debt fund had no choice, therefore, but to value that bond at maximum 13%.

“Post June 2012, debt fund NAVs should be in a better position to capture these market movements", says Vikrant Mehta, head–fixed income, AIG Global Asset Management Co. (India) Ltd.

The new Sebi guidelines have removed the defined mark-ups and have left it upon the fund manager to decide an appropriate mark-up or mark-down.

60-day limit: This is a simple rule. Effective 30 September, all securities maturing after 60 days will be marked to market. Those securities that mature before 60 days will continue to be amortized (a method that debt funds use to value very short-term securities). However, amortization will need to be more realistic than before, following matrices very closely.

After Sebi gave fund houses the freedom to come out with their own valuation policies in February, there were discussions at the level of the Association of Mutual Funds in India (Amfi), the industry trade body. Then the Amfi valuations committee came up with a detailed set of guidelines— keeping in mind Sebi’s objective to value securities as realistically as possible—to guide the MF industry. All AMCs have largely stuck to these guidelines with some variations here and there.

We checked out the debt fund valuation policies of seven fund houses including larger ones such as HDFC Asset Management Co. Ltd and ICICI Prudential Asset Management Co. Ltd to smaller ones such as AIG Global Asset Management Co. (India) Pvt. Ltd to get an idea of what fund houses are up to. Mostly, their policies are the same with negligible differences. Sebi has asked fund houses to review the policies periodically.

kayezad.a@livemint.com

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Published: 09 Sep 2012, 10:25 PM IST
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