The Securities and Exchange Board of India (Sebi) has taken yet another step in bringing about reforms in the mutual fund industry that were initiated in the wake of the credit crisis, which had also engulfed the industry in late 2008. During that time, there was a wave of unexpected redemptions from short-term debt funds in a panic induced by the credit crisis. When fund companies tried to liquidate funds’ holdings, the frozen credit markets and illiquid assets meant that they were unable to realise the value that was implicit in the net asset values (NAVs) at which redemptions were made. The problem was tided over by the Reserve Bank of India (RBI) opening a special financing window for funds and in some cases, by the asset management companies (AMCs), and their parent companies, taking illiquid paper and some losses on themselves.

However, ever since that time, the regulator has been clear that the root cause of the problem is that there was a discrepancy between the value of the bonds held by funds as reflected in the NAV and the real value that is realisable in the market. The latest step is an attempt to eliminate that discrepancy. From July 1, onwards, the NAV of liquid funds will have to be more closely based on the market value of the securities held by such funds. This is likely to increase the volatility of these funds’ day-to-day NAV movements. Currently, the NAV of these funds is almost perfectly predictable. This predictability arises from the fact that these funds hold bonds that are expiring within 91 days at most and under current norms, funds can value such bonds according to the interest accrual alone. This results in a straight line appreciation that is identical to the gains that would accrue if the bond were to be held to maturity.

AMCs know that the utter predictability of liquid funds’ returns is a core characteristic that makes them attractive to investors. If this is compromised even a little, then the very nature of the product changes and many investors will take another look at these funds. It’s likely that liquid funds will become markedly less attractive to investors who use them for parking cash for periods up to three or four days. Longer than that, volatility may not be an issue. However, the final decider will be each investor’s own psychology – how many will be comfortable with any volatility at all in a product where there was none previously. At the end of the day, liquid funds are attractive to chief financial officers (CFOs) because they have slightly better returns and more tax-efficiency than competing products. Even the smallest volatility adds a new variable to the equation that decides the worth of the entire product.

Corporates who park cash in liquid funds have to come to terms with the fact that a liquid fund is not a bank deposit – it can only be treated like one under normal circumstances. If circumstances as abnormal as the ones in 2008 recur, then investors will lose their money. Last time, such losses were mostly prevented by some extraordinary measures taken by the Sebi and the RBI.

At the end of the day, this is not a solvable problem. Stripped to the basics, liquid funds are an attempt to create a product which can be genuinely produced only if India had a much bigger and more liquid bond market. If the illiquidity and the volatility implied by the thinness of the underlying bond market leaks into this product, then the product becomes less useful – perhaps a lot less useful – for its customers. The only satisfactory solution would be a deeper bond market, but that’s a whole different story.

Author is CEO of Value Research