Opinion | How Sebi’s new policy fares

Sebi’s decision is a leap in the right direction and will build investor confidence in the industry

Liquid funds are the largest category of debt mutual funds. Association of Mutual Funds in India (Amfi) data suggests that this category of debt funds has seen largest growth this financial year, where every other category of debt funds has shown de-growth. And that’s not surprising, considering that the first half of FY19 saw liquidity tighten significantly, as currency with the public grew beyond the levels that existed prior to demonetisation and RBI had to step in to stem the volatility in the rupee in the foreign exchange market.

With both phenomena hitting the system simultaneously, debt markets naturally reacted negatively with yields rising across the curve. RBI responded by raising rates by 25 bps each, in June and August 2018. It was natural for debt investors to take a conservative view on rates and move allocations to the liquid category from the income categories. Liquid funds, by regulation, can only invest in securities maturing within the next 91 days.

The credit events, as of September 2018, and its effect on the non-banking finance companies (NBFCs) and housing finance companies (HFCs) caused money market rates to spike and investor withdrawals from liquid funds. This brought to the fore the need to revisit industry valuation norms to better reflect market risks within the liquid fund category. Securities and Exchange Board of India (Sebi), in its board meeting on 1 March has decided to implement key changes in the valuation norms, the most significant of which is that all securities beyond 30 days would be subject to daily mark-to-market (MTM). This is currently being done only for securities beyond 60 days and so, most liquid fund portfolios were immune to small yield changes. On most days, daily returns of liquid funds do not deviate much from the portfolios’ yield to maturity (YTM) net of expense. However, this only serves to impart a false sense of comfort to investors as when the funds witness sharp redemptions and need to liquidate securities in the market, the true value of the securities is actually realised.

All this is set to change. With all securities above 30 days being subject to daily MTM, a significantly higher proportion of the portfolios will be revalued daily. This will result in higher deviation of daily returns from the net YTM of the fund and hence higher volatility.

While upside to returns is palatable to investors, the downside risk needs investors’ attention. The natural response from a portfolio manager’s perspective would be to reduce portfolio maturity. But this is easier said than done. Issuances in money markets are largely driven by the issuers’ liquidity and ALM requirements . In fact, issuers would be willing to offer better rates for their choice of maturity in a tight liquidity environment rather than exposing themselves to the vagaries of the market more frequently. This phenomenon is not new. Hence, from a markets perspective, the yield curve may actually steepen.

So what does all this mean for the investor? Most investors in liquid funds need not worry. Average maturities of liquid funds usually range from 30 to 60 days. Industry estimates suggest that about 80-85% of liquid fund investors park their investments for more than a fortnight. For such investors, the enhanced daily volatility in returns will eventually cancel out and investors may ultimately earn a return closer to the portfolio’s net YTM. However, the balance 15-20% of investors who park their money for short periods of time may need to be more cautious.

Fortunately, another category of debt funds has gained popularity: overnight funds. These funds invest only in overnight instruments and so has the least interest rate risk. Short term investors who are apprehensive about volatility in daily returns can park their money in such funds, even though YTM of such funds in lower than liquid funds. In summary, Sebi’s decision is a leap in the right direction and will build investor confidence in the industry. The last time the liquid category witnessed a major regulatory change was in the aftermath of the global financial crisis over a decade ago. We have seen the category grow, as investors and portfolio managers alike adjusted to the new regime. One is confident history will repeat itself.

Kalpen Parekh, president of DSP Investment Managers Pvt. Ltd