Liquid funds are now poised for better liquidity management, with a slight dent in the return profile, and higher short-term volatility
04-Sep-2020 •Sneha Suri
On 30th June, new regulations for liquid funds came into effect. These include holding a minimum of 20 per cent of net assets in liquid securities, such as cash, government securities, repo on government securities and T-bills, and dispensing with the amortisation-based valuation in favour of mark-to-market valuation of the portfolio. Let's take a look at how these regulations impact your liquid funds.
Higher liquid assets
Liquid funds used to hold around 10 per cent of their AUM in cash, treasury bills and government securities. But due to the default by IL&FS, a AAA rated issuer, and the after-effects of this episode, SEBI felt the need to strengthen the risk-management framework of these funds from a liquidity standpoint. Hence, it mandated liquid funds to increase their investments in liquid assets to at least 20 per cent of their AUM. What about the returns profile of liquid funds now?
To assess the impact on returns, we compared the yields on three-month treasury bills (T-bills) with those on certificates of deposit (CDs) of a similar duration issued by banks. Being the next-most liquid asset, CDs are the likeliest to get substituted by T-bills in liquid-fund portfolios in order to comply with the new regulation. So effectively, liquid funds give up on the yield on CDs (for about 10 per cent of the AUM) for the yield on T-bills. The spreads between these two keep fluctuating. In fact, they have come down to zero in recent weeks. But these are unprecedented times with massive central-bank interventions. So, excluding these last few months, the spreads between bank CDs and T-bills have broadly trended in the range of 20-50 basis points in the preceding one year. That translates into a dent of just about 2-5 basis points to the returns of liquid funds. Not much! So there may not be a meaningful impact on the returns of your liquid funds purely on account of this new regulation.
SEBI has progressively moved to mark-to-market valuation norms. In February 2010, it had limited the applicability of amortisation-based valuation method to only securities with a residual maturity of up to 91 days. This duration was decreased to 60 days in February 2012 and then to 30 days in early 2019.
Now it has been done away with even for securities of up to 30 days' maturity. Therefore, these securities will now be valued at the average of prices obtained from valuation agencies. These securities make up over 40 per cent of the portfolios of liquid funds on an average. So, there may be a bump in the volatility on a day-today basis. But the actual impact on your returns will depend upon your investment horizon. "If the tenure of your investment is much lower than the average maturity of the fund, you are subjected to the vagaries of the market. On the other hand, if it is close to or greater than the average maturity of the portfolio, the impact will be muted. So, the mark-to-market impact for you reduces progressively as your holding period increases," says Kedar Karnik, Fund Manager, DSP Mutual Fund. Moreover, moving completely to the mark-to-market valuation method ensures that all investors - the ones exiting, entering and who remain invested - get a fair deal. That's because the NAVs will reflect the market-linked valuation of the entire portfolio at all times.
In sum, if you are investing for just a week or two, these regulations may make liquid funds less attractive. "You have an exit load for investments in liquid funds of up to seven days. Now there is a stamp duty applicable as well. But as your investment horizon increases, it reduces the negative impact of each of these variables on realised returns - the market variability, stamp duty and exit load. Therefore, I believe that if you have to park your money for less than two to three weeks, it is better to do so in an overnight fund purely from a risk- reward perspective," says Kedar.