Liquid funds have long been a popular avenue for investors, especially institutional, with a very short-term horizon.
With the change in threshold of amortisation of securities to 30 days from 60 days previously, the Indian mutual fund industry is expected become a leading example of mark-to-market (MTM) valuation of debt securities in the world. Indeed, even in a developed market such as the US, the amortisation rule for money market funds has restricted the weighted average maturity of a fund to 60 days since 2010, although down from 91 days earlier.
In addition to the reduction in threshold, the Securities and Exchange Board of India (Sebi) has modified the amortisation rule to 0.025% of the reference compared with 0.10% earlier, to bring the reset price close to market price.
While the changes are applicable to the entire industry, the biggest impact is expected to be on liquid funds, which have been the biggest beneficiary of the amortisation rule.
What prompted the change?
Securities and Exchange Board of India (SEBI) modified the valuation of money market instruments in 2010 and prescribed a threshold of 91 days for marking securities to market from 180 days earlier. This was brought down further to 60 days in 2013, and will now reduce to 30 days.
The latest move comes in the wake of credit worries and the ensuing liquidity crisis that engulfed the mutual fund industry between September and December 2018. The liquidity concerns, coupled with quarterly advance tax requirements by corporates had caused a record outflow of Rs 2.11 lakh crore from liquid funds in September.
How it impacts liquid funds
Liquid funds have long been a popular avenue for investors, especially institutional, with a very short-term horizon, given the stable returns these offer compared with other debt mutual fund categories.
The stable performance was driven by SEBI valuation guidelines that allow mutual funds to amortise investments in the less than 60 days’ maturity bucket, thus reducing the volatility that typically emanates from mark-to-market (MTM) valuations.
Now, to comply with the regulator’s rule, the category is expected to go down the maturity bucket (<30 days) in terms of investment allocation, and thus amortise majority of its invested securities, to keep the returns stable.
What this means for investors
The change in the threshold level for amortisation to 30 days will have an impact on both the returns and the volatility of liquid funds.
Given the preference for capital protection and stable returns of institutional investors (who are the dominant investors in the liquid fund space), funds would look to bring down the average maturity profile and keep MTM low.
Our analysis shows that to maintain current volatility levels, category funds will have to keep 50/50 share of amortised and MTM. But this will shave off a few basis points from average returns.
What proportion of portfolio will go down to below 30 days will be determined by expected supply of fixed-income securities in the less than 30 days maturity bucket, which could also be an outcome of the cost for issuers because of higher churn in issuances. Overall, from a debt market perspective, the likely fall in returns could steepen the yield curve.
In case there is a sharper fall in returns from the category, some investors with higher risk appetite could look at rebalancing their portfolios to higher-yield, higher-risk categories such as ultra-short and money market funds, which have slightly longer maturity compared with liquid funds, or at overnight funds in the lower investment horizon that carry the least interest rate risk.
For retail investors looking to invest a lump-sum in equity-oriented funds, systematic transfer plans through liquid funds remains a good investment strategy.
(By Bhushan Kedar, director, Funds Research, CRISIL)