Mark-to-market profile needed for liquid funds
The returns from liquid or any bond fund are not and should not remain linear
In June 2012, Sebi came out with two polices of prescriptive nature for mutual funds—one was on advertising guidelines and the other on fair valuation of securities. Debt funds usually need guidance on how to value their securities as debt securities are typically not much traded unlike listed equity shares. The challenge is how to measure them fairly. Sebi laid down a board framework on the “spirit” of the policy and advised asset management companies (AMCs) to have an internal fair valuation policy based on the “principles” and have it approved by the Mutual Funds Board of Trustees.
It was indeed a much-needed move to bring in transparency, rationality and objectivity to the way mutual funds can value their portfolio holdings and that the daily declared NAV (net asset value) is as close to the realisable value of those underlying securities if one had to liquidate those assets in the market.
Being a principle-based policy as against a prescriptive policy also puts the onus on the AMC to frame internal policies that will meet with the spirit of the guideline as the regulator retained the over-riding right of interpreting and questioning fair valuation.
Indian equities were easy to value as a majority of widely-held securities are traded and quoted on the stock exchange and “Bhav Copy” (a newsletter that compiles the stock prices of all listed securities) becomes a reasonably good measure of industry-wide common valuation source.
Indian bonds though were tricky. Government bonds trade on screen and those that don’t have other sources of mark-to-model pricing by agencies like Clearing Corp. of India Ltd and Fixed Income and Money Market Dealers Association. Indian corporate bonds don’t trade on screen and a very small percentage of the overall outstanding gets traded and reported on the exchange. Till June 2012, corporate bonds were valued based on internal policies with some help from external valuing agencies. With Sebi getting stricter, and AMCs not wanting to take up the onus of determining fair valuation; they found a common industry-wide similar valuation practice by appointing entities of Crisil and ICRA to provide daily valuation for all debt instruments. Since 2012, Crisil and ICRA have been providing the fair (traded) prices of all securities to all fund houses, which are required to use the list to value holdings and then come up with debt schemes’ NAVs.
This was a good outcome as bonds would now be valued by an external and independent agency and each bond would have a common price across all fund houses. This was a good outcome also because prior to this, there may have been instances of one bond being valued at two different prices by the same fund house in two different schemes. The industry has come a long way since then on the issue of fair valuation but for one particular aspect.
Even now, Crisil and ICRA daily list of securities and their fair prices pertain to securities that are 60 or more days old. Bond instruments maturing in less than 60 days are not “fairly valued”. The industry then had argued that liquid funds which typically invest in less than 90-day instruments, if moved to daily mark-to-market on fair valuation, would provide “volatile” returns which may not be palatable to large institutional investors who invest their cash surplus in these. They said that those investors will move to investing in bank FDs and mutual funds will lose out.
So if a fund house owns any instrument which has a maturity below 60 days, it can choose to not mark-to-market it daily, resulting in a situation where the market price of the instrument could be at odds with the price at which the NAV was calculated.
Take examples of defaults in liquid funds in the last three years. In most cases, they have been in instruments with less than 60 days’ maturity. So, it could have so happened that fund houses have been valuing that paper at an “artificially” high price not recognising the actual market value of that bond prior to default. Thus, most funds took large hits on the day of default or a downgrade by rating agencies as against already accounting for some erosion in value, if they were aware of it.
Sebi should mandate all instruments to be compulsorily marked-to-market without exception. Liquid funds or, for that matter, any bond funds are not fixed deposits. The returns of these funds are not and should not remain linear. I believe, Sebi in their policy blueprint would have decided to move all instruments to fair valuation at some point in time. That time has come.
Arvind Chari is head, fixed income and alternatives, at Quantum Advisors
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