A Sebi mandate that debt instruments with more than 30 days to maturity need to be valued on a ‘mark to market’ basis will make NAVs of short-term debt funds more reflective of their actual market value
Investors should evaluate and identify liquid funds that hold instruments with less than 30 days to maturity
Liquid funds are poised to see a change in the risk and return profile with capital markets regulator Securities and Exchange Board of India (Sebi) tightening the rules governing valuation of money market securities in debt fund portfolios. Sebi, in a circular issued on 1 March, mandated that debt instruments with more than 30 days to maturity will now have to be valued on a “mark to market" basis.
The move is expected to make the net asset values (NAVs) of short-term debt funds such as liquid funds more reflective of the value that the instruments can actually realise in the market.
What’s the change?
Until now instruments with up to 60 days to maturity were valued on amortisation basis, where the difference between the purchase and redemption prices on maturity of the instrument, or the return from the fund, was amortised or spread over the tenor of the instrument. For example, if an instrument is purchased at ₹98.5 and matures at ₹100 in 60 days, then the return the fund will earn over the period is ₹1.50. This is amortised over 60 days with 2.5 paisa being added to the value of the instrument each day.
The value of the instrument in the portfolio that is amortised increased linearly each day. For debt funds that predominantly invest in this space, such as liquid funds, this meant that the NAV moved up daily and saw no volatility and investors who parked funds in such funds for short periods were confident that their capital invested was safe.
So why did Sebi feel this had to change? For one, this was just an accounting value and not the realisable value of the instrument. If the fund had to liquidate this instrument in the market, then the realised value would likely be lower than the value at which the instrument is valued for the calculation of the NAV leading to a sharp cut in the NAV, and consequently a fall in the returns from the fund.
“Liquid funds are not and should not be treated as bank deposits. Thus, straight-line NAVs like bank deposit returns are mis-leading and lull investors and fund managers into complacency. In the event of a tight liquidity or a credit event, the fund’s NAV suddenly reflects the true value as against in a fully daily MTM portfolio where the NAVs would have already represented the increase in yields," said Arvind Chari, head, fixed income and alternatives, Quantum Advisors Pvt. Ltd.
Amortisation allows fund managers to be complacent and hide the true market value, he added. “Given the cases of defaults in liquid funds, one needs to ask whether those securities prior to default continued to be amortised and thus not reflect its deterioration in its value. For example, in the case of IL&FS, market yields had moved higher prior to the default, but did liquid fund NAVs reflect that increase in yields or fall in prices?" asked Chari.
Marking the security to market has the advantage of reflecting its realisable value and, in turn, make the NAV “real".
What it means for investors
When securities are marked to market, their values may go up or down from one day to the next and, therefore, the NAV will fluctuate too. Funds that hold a significant portion of their portfolio in securities within the maturity band of 30-60 days will see less predictability in their NAVs compared to earlier when this part of the portfolio was valued on amortisation basis.
The category of funds that is likely to be most affected by this regulation is liquid funds which by regulation cannot hold securities with maturities greater than 91 days. Liquid fund investors seek daily liquidity, safety of capital and stability in returns. Any fluctuation in returns, particularly on the negative side, may not be acceptable to investors who use liquid funds to park their money for very short periods.
A quick scan of liquid fund portfolios as on 27 February 2019 shows that 41% of the funds have portfolios with less than 30 days to maturity and, thus, the new directive will not have much impact on their current portfolios. Of the rest, many of the funds have durations not exceeding 35 days where the impact will be negligible. A few funds have portfolio duration of 50-70 days and they may see some volatility. “With the change in valuation norms, liquid funds would witness marginal reduction in maturity profile, to enable stability in the returns profile. We do not expect significant changes to the return profile with a marginal reduction in maturity," said Saurabh Bhatia, vice-president, fixed income, DSP Mutual Fund.
What the regulation does is to make investors and liquid funds take a call on the portfolio that they are most comfortable with. Institutional investors, who do not want to see any chance of volatility at all, may shift to the overnight fund category that invests in securities with one day to maturity and, thus, eliminate all credit and interest rate risks, albeit with lower returns.
“Overnight funds have been finding flavour with investors parking money for very short terms. The horizon of investments along with the spreads between liquid funds and overnight funds will continue to remain the key determinant for investors’ choice in this category of funds," said Bhatia.
Investors seeking the earlier stability of NAV along with better returns should evaluate and identify liquid funds that choose to hold instruments with less than 30 days to maturity. Such investors will have to forego the better returns that funds with higher maturities may offer.
Investors who are willing to ride the fluctuations that can come into a portfolio can consider liquid funds holding securities with longer tenors. But they should choose only those that come with good credit quality and have strict monitoring in place, so that unexpected credit situations can’t bring down the values sharply.