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Liquid Funds Underperform

Falling interest rates are a party time for most debt mutual funds. But there's one category of debt funds that doesn't benefit from falling rates - liquid funds

Consider the double-digit returns notched up by gilt funds and income funds in the last one year. As repo rates have fallen from 8 per cent to 7.5 per cent with RBI cuts, medium- and long-term gilt funds have risen quickly to the top of the debt category, with a one-year return of nearly 19 per cent. Income funds have earned 14 per cent; and even short-term income funds, nearly 11 per cent.

But liquid funds, which were top performers in the debt category a year ago, are now the worst in the debt category, with one year returns of 8.7 per cent. If we slice and dice liquid fund returns further for the last one year, it is clear that the returns are diminishing further with falling interest rates.

While the average one-year return for the liquid fund category is 8.76 per cent, it was only 4.23 per cent for the last six months (without annualising) and 2.08 per cent for the last 3 months. If you annualise these numbers, you will find that the annual rate of return of liquid funds is now close to 8.32 per cent, far lower than the 9 per cent plus returns earned a couple of years ago.

Now, why have liquid funds earned lower returns with falling rates while other debt funds have made merry? Well, the answer lies in the manner in which different kinds of debt funds earn their returns. Funds which invest in G-secs or corporate bonds with a medium to long maturity earn a good portion of their returns from the price appreciation (or depreciation) on the bonds which they hold. So, when the market interest rates are declining, their older bonds, which earn higher rates are much in demand. Their prices appreciate thus boosting fund NAVs. Though the interest that they earn on newer bonds will decline, the capital gains on the older bonds tend to boost overall returns.

In contrast, liquid funds invest much of their portfolio in very short-term treasuries or money market instruments. Therefore, they earn much of their returns from the interest they receive on their bonds. The 'capital appreciation' part is very limited, given that the maturity of the bonds they hold is just one to three months. If rates are falling and as the debt securities held by these funds mature, they are forced to re-invest their money at lower and lower interest rates. Therefore, their overall returns tend to head south with interest rates too.

An analysis of liquid funds by Value Research showed that the average maturity of liquid funds as of end February 2015 was about 25 days. Therefore, these funds essentially 'reset' their rates every 25 days as their old instruments mature and they look for new securities. That's why as interest rates fall further, you should expect liquid fund returns to fall too in line with short-term and call money rates in the market. But will liquid funds make good investments then?

Yes, because for investors in higher tax brackets, they will still yield higher returns than 4-6 per cent interest-earning savings bank accounts. There's another point to note too. Liquid fund returns carry far lower risks than gilt or income funds because they aren't sensitive to interest rate swings.

If the declining trend in interest rates were to halt tomorrow, gilt and income fund returns will suffer a sharp setback. But liquid funds won't because they don't rely as much on bond price volatility for their returns.

Tracking Returns

Category20102011201220132014YTD ret (%)#
Short-Term Debt4.849.069.87.6710.69.6
Ultra Short Term5.188.879.418.79.128.78
Medium- & Long-Term Gilt4.45.7710.523.4416.6912.09
Short-Term Gilt4.
# As on March 31, 2015