There seems to be a notion that debt funds have now got riskier thanks to the latest regulations implemented by the Securities and Exchange Board of India (SEBI). Well, they can certainly deliver negative returns now, but this is an outcome of a much more transparent process. Nothing intrinsic has changed about the investment process.
From August 1, 2010, all debt funds now value their paper according to the prevailing market price if they mature after a period of three months. Earlier they had to do so if the maturity period was six months.
The moment the new regulation was announced towards the end of the day on February 2, 2010, there was an instant aversion from fund managers towards buying longer-tenure paper. In fact, the very next day, Reuters reported the raising of short-term debt by two financial institutions. According to the report, Housing Development Finance Corp (HDFC) and Infrastructure Development Finance Co (IDFC) raised a total Rs 8 billion. This was the second Commercial Paper (CP) issuance this year (the first being Exim Bank). HDFC sold Rs 5 billion of CP yielding 5.80 per cent and IDFC sold Rs 3 billion of 5.80 per cent notes, both maturing in September 2010.
Mutual funds, the largest buyers of such debt, wanted to ensure that on August 1, 2010, (when the regulation comes into effect), the paper they hold does not have a balance maturity of more than 90 days. Why? Because, more often than not, less than 90-day paper is not traded by mutual funds. If paper up to three months maturity is not traded, then it need not be valued at the current market price and can be valued on an amortisation basis.
A fall-out of this regulation (of mark-to-market) would be greater volatility. The cover of not having to mark-to-market and, therefore, insulating the schemes from market volatility will go. AMCs will now have to factor in any drop in securities' prices on a daily basis while calculating a scheme's net asset value (NAV). Consequently, there is a strong possibility of negative returns on certain days as well as higher volatility in the NAVs of short- and ultra short-term debt funds. Under the prevailing amortisation method, the NAVs are consistent. Liquid funds, on the other hand, will remain safer, so to speak, as they cannot invest in paper that matures after 90 days. So if the paper is not traded, they need not mark-to-market it.