Capital markets regulator Securities and Exchange Board of India (Sebi) has moved to streamline the risks in liquid funds by tightening the investment and valuation norms. At its board meeting in end June, Sebi decided to adopt new rules that may restrict liquidity, make net asset values (NAVs) volatile and lower returns. But can these rules make the liquid fund product category irrelevant?

The liquid fund space has a giant 24% share of the mutual fund pie and 6 trillion in assets under management (AUM). Though the number of institutional investors are significantly higher in this category, it attracts retail investors too.

So why did the market regulator feel the need to tinker with the liquid fund model?

Existing model

Investors choose liquid funds as they give better returns than a bank account while providing liquidity with features such as redemption within 24 hours and instant withdrawal up to 50,000. Liquid funds, which are open-ended, allow investors to tailor the holding period to their needs, a facility that bank deposits do not extend.

And, their model allows them to show stable net asset values (NAVs). Liquid funds are not required to mark to market securities with maturities less than 30 days. So funds managed volatility in prices by holding such securities and amortized the interest earned over the tenor by adding interest for each day. This gave stability, albeit artificial, to NAVs of liquid funds. These funds were offering immediate and T+1 redemption, while the portfolio was invested mostly in securities with maturities up to 30 days. Funds managed the liquidity by holding some portion of the portfolio in cash and equivalents and even resorting to borrowing, if required, within regulatory limits.

Sebi has now been seized by the what-if scenarios in this model. What if the inflows were much lower than the redemptions? What if the securities in the portfolio had to be sold in a crunch situation and the market value was lower than the accounting value? What if there was a credit event?

The changes

The decisions are a continuation of the steps Sebi took in March 2019 to de-risk the debt fund category. The subsequent credit events such as the downgrade of debt securities of the Essel and DHFL groups brought to the fore the liquidity and credit risks in debt funds.

Sebi now intends to mandate that liquid funds, to manage the need for liquidity, will hold at least 20% of assets in liquid products such as cash and cash equivalents, government securities (G-secs), treasury bills (T-bills) and repo on government securities.

A graded exit load will be levied on investors who stay in a scheme only up to seven days. This will allow better visibility to managers to manage inflows and outflows.

It has also decided to curtail the exposure to sectors and securities. The funds can now invest only 20% in a particular sector. The 15% additional exposure to housing finance companies (HFCs) has been restructured to 10% in HFCs and 5% in securitized debt with the underlying assets being retail and affordable housing loan portfolios.

The regulator has also decided to prevent liquid and overnight funds from investing in short-term deposits and debt and money market instruments having credit enhancements. Also, mutual fund schemes will be allowed to only invest in listed non-convertible debentures (NCDs), including commercial papers (CPs), where greater regulation and disclosures are likely.

Finally, Sebi intends to do away with amortization-based valuation and liquid funds will now have to mark to market their entire portfolio. This means that the NAV of the scheme will reflect the prices of the securities in the market, though the changes in market prices will lead to some volatility in NAVs.

What it Means for you

The new rules are expected to fortify investors in liquid schemes against the effects of sudden excessive redemptions and credit events.

While all securities being marked to market may lead to some volatility in the NAVs, it will also become truer and realizable.

The exit load up to seven days may be seen as curbing liquidity for investors but what it also does is limit lumpy flows as institutional investors move money in and out in a very short span to benefit from opportunities. Such fund flows may be detrimental to the interests of retail investors, especially when there is a liquidity or credit crisis in the market. “Liquid funds were meant to be a cash management product, not an investment product and Sebi’s rules will serve to better reveal the true risk in the product," said Suyash Choudhary, head, fixed income at IDFC Mutual Fund. “This also now provides a positioning choice to the manager depending upon how much volatility one wants to build into the return profile," he added.

For investors who genuinely have a shorter holding period, overnight funds will be more appropriate, and liquid funds may see outflows into overnight funds. “Once funds adopt full mark-to-market status, some investors may choose to move one step down into overnight funds since that is the only fund with zero credit risk and zero interest rate risk and gives you some return linked to repo rates. Some investors may choose to move one level up and move money into the ultra-short category. If at all you are going to take mark-to-market risk, you may as well do it in the three-six months bucket for better risk-adjusted returns," said Rajeev Radhakrishnan, head, fixed income, SBI Mutual Fund.

The requirement of maintaining 20% in prescribed liquid assets while enhancing the liquidity features of the product will impact the returns from the fund, and so will the restrictions on the type of products that the liquid fund can invest in. However, for liquid fund investors, liquidity and safety comes first and returns later. Renu Maheshwari, chief executive officer and principal advisor at Finzscholarz Wealth Managers LLP, does not see these rules affecting the decisions of her retail investors to hold money in liquid funds for contingencies or for reinvestment. “Returns were never the driving reason for selecting liquid funds. The liquidity and safety features have just been reinforced by the new rules," she said. “We have suggested corporate investors to consider moving to overnight funds based on their holding period," she added.

Mint’s take

Many of the better-managed funds have internal guidelines and monitoring practices in place to ensure adequate liquidity. The guidelines will ensure that all funds have proper safeguards.

The mark-to-market guidelines and the exit loads may lead to polarization in the liquid fund category. Some funds may choose to invest in securities with short tenors to give investors lower but stable returns. Others may choose to invest in slightly longer duration securities to give higher returns from gains in price though this may come with greater volatility in NAVs. “There is a possibility of dispersion in the liquid fund category with some funds choosing to increase their maturity to up to 91 days. But most of them may stay in the 35-40-day maturity bucket," said Radhakrishnan. If this happens, investors may have to take greater care in selecting liquid funds that meet their risk comfort.

If the funds have to be held for really short periods of less than seven days, then overnight funds will be the most suitable.