Why liquid funds may soon lose their sheen

Debt funds will now have to value debt papers as per the prevailing market prices if they mature after three months, up from the earlier six months

One of the least risky products in the mutual funds (MF) space just got riskier. From 1 July, all debt funds will have to value their debt papers as per the prevailing market prices if they mature after a period of three months, down from the earlier six months. The Securities and Exchange Board of India (Sebi) made this mandatory through a circular issued on 2 February.

Money market instruments will also be valued similarly, said Sebi. This means that your ultra short-term (ST) fund, earlier known as liquid-plus schemes, will become riskier.

The problem

When the markets fell in 2008, investors made a rush for redemptions. MFs had to arrange for cash on a short notice since they did not anticipate so many redemptions. They had to sell assets at throwaway prices and incur losses. Three ultra ST funds gave negative returns, contrary to expectations.

Earlier, debt securities maturing before six months were not required to reflect their prevailing market prices. They used the amortization method. To put it simply, if your debt fund invested in a debt security with a face value of Rs100, carrying a coupon rate of 5% per annum and matured in five months, it would have spread the total interest income of Rs2.10—or Rs0.014 per day—over the debt paper’s tenure. In other words, only those securities that mature after six months would reflect market’s volatility depending on how their market prices move. Also, money market instruments—in which ultra ST funds invest a chunk of their assets—were valued through the amortization method, as per Sebi rules.

In 2008, when the debt markets turned volatile, ultra ST funds did not reflect the reality and their net asset values (NAVs) continued to show a steady rise. A chief investment officer of a leading asset management company said, on condition of anonymity: “Debt funds with shorter duration had large maturity scrips, out of line with their risk profile. Also, much of these debt papers were not valued, giving a false sense of stability to investors.”

Ever since, Sebi has taken corrective steps to ensure that MFs are in line with their objectives and do not convey a message that is not in sync with what they can actually offer.

What has changed?

Sebi now wants debt funds to value their underlying securities more realistically. They will now have to mark-to-market all those debt papers that mature after 91 days. Money market instruments, such as certificates of deposit, commercial papers, collaterized lending and borrowing offerings, were not marked to market even when they matured after six months. Now, these too will be marked to market.

As most ultra ST funds invest up to 90% of their corpus in such instruments, they are set to become more volatile. “Ultra ST funds invest significantly in money market instruments. Now their NAVs will be more volatile and they can also give negative returns on some days,” says Mahendra Jajoo, head (fixed income), Pramerica Asset Managers India Ltd, which is waiting for Sebi’s second-stage license to start its MF operations in India.

They will be more realistically priced as most of their underlying instruments will reflect the prevailing market price.

More realistic

Ultra ST funds are set to lose sheen as they will now be more realistically priced. Fund houses introduced these funds in 2007 when the year’s budget increased the dividend distribution tax (DDT) for corporates from 14.03% to 28.03% in liquid funds. Ultra ST funds were devised to provide liquidity with the tax advantage.

Your fund manager’s skills would be tested to the hilt. “Fund managers will have to sharpen their skills to be able to dynamically manage the duration of funds and debt papers,” said Maneesh Dangi, head (fixed income), Birla Sun Life Asset Management Co. Ltd. “Liquid funds are safer as they can’t invest in debt papers that mature after 90 days,” said Arvind Chari, debt fund manager, Quantum Asset Management Co. Ltd.

Industry sources say that Sebi’s latest move is just the beginning. To ensure that a October 2008-type crisis is not repeated and corporate investors do not use the MF route to save taxes, the coming Budget may plug the loopholes, experts predict. Just like liquid funds, ultra ST funds may also have to pay higher DDT to reduce the tax arbitrage that corporates now enjoy.

Ultimately, such moves will only help the industry focus more on retail than institutional investors. About 66% of the industry’s corpus lies in ultra ST and liquid funds as per the December figures released by the Association of Mutual Funds of India. Reforms such as these would nudge the industry to focus more on retail investors.

Source: http://www.livemint.com/2010/02/08211205/Why-liquid-funds-may-soon-lose.html