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Liquid Funds on Death-Watch

The October, 2008 crisis dealt them a massive blow, and consequences thereof have added to the injury

Back in January, market regulator, the Securities and Exchange Board of India (SEBI), unveiled a new rule which strictly limited the parameters within which liquid funds operated. These rules fully kicked in on May 1 and by now, their impact on this class of funds is clearly visible. Returns have dropped so sharply that it would be justifiable to harbour doubts about their continued existence, at least in the current shape.

Like so much of what has happened on the regulatory front in the last few months, the changes that SEBI mandated arose from October, 2008 credit crisis. Liquid funds are meant for parking cash that investors have lying idle for short-term periods that range from a couple of days to at most a few weeks.

They are supposed to have portfolios that are essentially risk-free. To do this, investment managers should invest in debt instruments with an extremely short residual maturity, simply because such investments react little to any changes in interest rates. Ideally, this means avoiding anything that is maturing in more than two or three months. However, there was no rule governing this. Since longer maturity investments carry higher returns (albeit at higher risk), most fund managers drifted towards longer and longer maturities. So much so that there were liquid funds that were running average maturities of almost an year.

During the October crisis, this engendered a disaster. Many funds that had stretched their portfolios beyond safe limits lost money. In some cases, asset management companies (AMCs) and parent companies had to come to the rescue. In January this year, SEBI brought out a circular that asked liquid funds to shorten their maximum maturities to six months by February 1 and further to three months by
May 1.

The impact that this change was to have on the returns of liquid funds is now clear and the news is not good. The average annual returns of liquid funds in 2007 were 7.76 per cent and in 2008 they were 8.76 per cent. In most quarters, returns varied from about 1.6 per cent to as high as 2.2 per cent. These numbers have now come down drastically to around 1.1 per cent to 1.3 per cent. 1.1 per cent a quarter corresponds to about 4.5 per cent per annum. Bank term deposit rates are in the same region. State Bank of India offers 3 per cent for deposits of up to 45 days and 4 per cent up to 90 days. These are the time periods which compete with liquid funds.

Although funds still have an edge in returns over banks (and a tax arbitrage too), but the margin is smaller than ever. And of course, after last year’s experience, the much higher safety level of a bank also counts for something. For the short periods that such investments are made the absolute difference is small indeed. For a deposit of Rs 1 crore, the fund will earn an extra Rs 20,000 over 45 days compared to the bank. Even with the difference in taxation, this is not the kind of money that is very exciting for anyone. And once the direct tax code kicks-in, even the tax arbitrage will be gone.

It’s amply clear that the range of investors to whom liquid funds continue to make sense will become narrower. The asset base of these funds is a huge Rs 1.34 lakh crore out of the total of Rs 6.9 lakh crore that is managed by mutual funds in India. There’s little doubt that this will come down in the months to come.