Looking at liquid funds? Read the fine print

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Published: July 22, 2019 1:10:43 AM

While the markets regulator has put safety net around liquid funds after a few defaults, retail investors need to take more care in selecting the funds.

The proceeds of such schemes are invested by the mutual funds in paper having adequate liquidity in the market.

Last month, debt mutual fund schemes reported net outflows of Rs 1.74 lakh crore including open ended, close ended and interval schemes. Among this, liquid funds reported the largest outflow of Rs 1. 52 lakh crore, highest since September 2018. Other categories of debt funds such as credit-risk funds, low-duration, medium-duration funds, too, have reported outflows in June, according to Association of Mutual Funds in India.

Liquid funds are witnessing a host of changes in the investment and valuation norms by Securities and Exchange Board of India (Sebi) because of the credit worries and the liquidity concerns. Investors too, are apprehensive about the safety of debt funds, especially liquid funds where most companies park their surplus money.

The changes

The new rules require funds to mark-to-market all their holdings with maturities longer than 30 days. The threshold of amortisation of securities has been changed to 30 days from 60 days earlier. Earlier, only bonds maturing after 60 days were valued at market prices. Bonds with maturity of up to 60 days were valued on amortisation basis. In fact, Sebi had modified valuation of money market instruments in 2010 to a threshold of 91 days for marking securities to market from 180 days. It was further brought down to 60 days in 2013, and now reduces to 30 days.

Experts say given the preference for capital protection and stable returns of institutional investors, mutual funds will bring down the average maturity profile and keep the mark-to-market low. Liquid funds are popular with institutional investors for short-term investment because of the stable returns as compared with other debt mutual fund categories.

Sebi has mandated that liquid funds can invest a maximum of 20% of their assets in a single sector against the current cap of 25%. Fund managers will have to keep aside at least a fifth of their assets in cash equivalents to meet sudden redemption pressure. This was done in order to ring-fence retail investors from taking a sudden hit during volatile bond market situations when there is a huge default, like the case of Essel Group and DHFL.

In order to safeguard investors, Sebi has barred liquid and overnight funds from investing in debt instruments such as short-term deposits, debt and money market instruments having structured obligation. The regulator has also put in place stricter norms for promoters of listed companies to pledge their shares and enhance disclosure standards.

Getting popular with retail

While corporates account for the bulk of deposits in liquid fund, retail investors are deploying their surplus money in liquid fund. The proceeds of such schemes are invested by the mutual funds in paper having adequate liquidity in the market.
Retail investors were lapping up liquid funds as these offer higher returns than bank savings account and can be redeemed in a single working day. Retail investors put money in liquid funds for short periods ranging from one day to six months for short-term goals like paying children’s annual school fees, paying high-ticket insurance premiums and even saving for vacations. Also, investors often use liquid funds for investing in equity-oriented mutual funds through the systematic transfer plan. Liquid funds held for more than three years are eligible for long-term capital gains tax with indexation. If redeemed before one year, the investor will have to pay tax as per one’s tax slab.

What should one do

Experts say investors will have to take greater care in selecting liquid funds,and it is better to shift to overnight funds. In fact, overnight funds are better than liquid funds as they invest purely in bonds with maturity of only up to one day.

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