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When does a liquid fund give negative returns?

Dhirendra Kumar talks about the reasons why liquid funds can deliver negative returns

When can an investment in a liquid fund become negative? How does it recover?
- Manoj Kumar

If I have to classify the life of a liquid fund ever since they got started, or they have been made available to Indian investors, I would say that in the initial 10-11 years, they had extreme flexibility and were at liberty to do their valuation freely. Of course, gradually there was a ceiling on the duration of the bonds that they could hold and once that was put in place, they would normally not go beyond that.

In the initial 10-12 years, none of the liquid funds went down in value even on an overnight basis. The first time ever this happened was in one or two funds in the extreme situation in the 2008 crisis. However, during the 'taper tantrum', when the American Federal Reserve chief announced that the interest rates will go up, causing havoc in the bond markets globally, many of the liquid funds faced the decline in value on an overnight basis. But that decline in value was recovered in the next three-four days.

Of late, in the last one-and-a-half-two years, the regulation regarding the operating framework for liquid funds has undergone a change. The earlier very conservative liquid funds have now been slotted into a different category, which is, the overnight funds. So overnight funds are unlikely to be facing a situation where they will go down in value even on an overnight basis. The liquid funds can go down in value. However, the likelihood of them going down in value is not that often, owing to the stringent regulations. But, if at all that happens, the magnitude of that fall could be very nominal and can recover in seven-eight days.

Having said that, during the IL&FS fiasco, the AAA-rated commercial paper or the very short-term money market instruments issued by the company, which were held by several liquid funds saw a decline and were written-off. Thus, these funds could never recover that money. But that was a one-off example we have. We don't have too many other examples of that kind.

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