In just another month, short-term debt mutual funds, which make up an overwhelming proportion of the Indian mutual fund industry, are going to undergo a fundamental change. These products are the staple of corporate investments that are made in mutual funds. They are the most popular asset class in to which the Indian CFO parks short-term cash in order to generate safe and predictable returns. The predictability of the returns is a key reason why these products are used. However, under new valuation rules that SEBI has implemented, these funds are going to be a lot less predictable from July 1 onwards.
The reason for this change is that the daily valuation of these funds are going to be done on the basis of the market price of their investments, rather than a straight-line value calculated from their coupon rate, as has been the practice so far. The straight line value assumes that for bonds with only a small period of time left to go for their maturity, the market price is not material. The daily valuation for such bonds can be based on just the interest they earn every day.
This predictable valuation means that the daily NAVs of funds that invest only in such short-term bonds are predictable too. Investors can invest in them even for the shortest periods and know precisely how much can they expect the NAV to be each day in the future. Moreover, unlike bank deposits, it has so far been practical to make and redeem investments in these funds even for extremely short periods like a two or three days.
Now, all this is set to change. Up till now, funds could use straight-line values for bonds with less than 91 days remaining before maturity. Now, they will have to use market prices for such bonds. In case there is no market price because the bonds are not traded, then they can still use the straight-line price based on the amortisation. Practically speaking, this means that daily NAVs of these funds are no longer so precisely predictable. The NAV will still rise at a predictable rate, specially over periods of more than a few days. However, this predictability will be less trustworthy. The shorter the period, the less the predictability. Moreover, over very short periods the NAV can even move downwards. For many corporates, this would be a complete no-go. No one is interested in parking cash in an investment that has any chance, no matter how small, of making losses.
How this changes the business of mutual funds remains to be seen. These funds would still be very useful for corporates but their range of usefulness would decrease. The onus of explaining the impact of the changes and ensuring that investors do not take the wrong decisions lies with mutual funds.
Like many of the changes that SEBI has affected in mutual fund regulations in the last 18 months, this too is a side-effect of the financial crisis of October 2008. If a mutual fund's units are redeemed at a price that is unsupported by the market value of its investments, then some investors will effectively get returns that are either greater or less than what their money has actually earned. In a crisis-either a general crisis or one affecting just a particular bond-this effect would be all the more severe. Even though this change will create difficulties, it improves the basic nature of short-term funds.
This article was originally published on June 04, 2010.
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