Liquid funds to give returns in line with money markets

Sebi appears to be taking a leaf out of international experiences in valuation of liquid funds.

The Securities and Exchange Board of India (Sebi) has decided to change the valuation norms for debt and money-market instruments held by mutual funds. Instead of the earlier norm requiring these instruments to be marked to market, where the residual maturity exceeded 91 days, the new norms would see instruments with maturities of at least 60 days being marked to market (when these securities are not traded).

Over a period of time, Sebi has reduced the mark-to-market tenor from 1 year to 91 days to 60 days. In making the change, Sebi has expressed its desire that all types of investors—existing as well as those seeking to purchase or redeem—are treated fairly. Marking to market ensures that the portfolio value closely reflects the realizable value of the assets. In the case of equity funds, the well-traded and liquid nature of the equity market ensures that mutual fund net asset values (NAVs) capture the current value of the portfolio. The debt market remains illiquid and non-traded securities are valued using a valuation model.

For securities with up to 60 days of maturity, the valuation method would remain the same (amortization at cost). In amortization, there is the possibility that the price of the security could be substantially different from the market price. This could lead to over/under-valuation of the portfolio. The lowering of the mark-to-market threshold would ensure that the extent of valuation difference is minimized both in duration and amount. The benefit of the new norms would be in the reduction of over-valuation, which could affect the fund if it were to be subjected to large redemptions.

Sebi appears to be taking a leaf out of international experiences in valuation of liquid funds. In the US, for example, money-market funds are required to calculate a “shadow” price, which is disclosed with a two-month lag. In Europe, money-market funds are allowed to amortize as long as the weighted average maturity is less than 60 days (source Bank for International Settlements). The rationale for amortization in valuation is that for short maturity debt, daily volatility is quite small and the difference to market price would be negligible. For example, a three-month certificate of deposit (CD) would see its price change by only six basis points (bps) (0.06%) for a 25 bps change in the yield. A 60-day CD would see the price change by 4 bps for a similar magnitude change in yield.

Indeed the actual experience in the US suggests that deviations in the shadow price remain small—that the amortized value is close enough to the real value of the fund (source Investment Company Institute). Thus, the shadow price has not had a negative impact on the growth of the money-market industry. In this context, Sebi’s step may be seen as more restrictive than the international norm as it requires the marked-to-market prices to be used in the fund’s NAV rather than as a shadow NAV. This may result in an increase in investor perception of volatility even where it may not be justified.

The impact of the changed valuation norms would be felt most in the category of liquid funds, which invest exclusively in instruments that mature within 91 days. This category was defined by Sebi to provide a low volatility option for investors seeking to invest for the short term. The low-risk nature of this category has made it the option of choice for companies and retail investors in mutual funds who desire to park their short-term surplus. In view of the changed valuation norms, liquid funds are likely to change their portfolios to invest in instruments with shorter tenor. This would be consistent with the investor preference of low volatility.

For the money markets, liquid funds remain key providers of liquidity. For example, liquid funds are among the largest investors in CDs and commercial papers (CP), apart from being key participants in repo and collateralized borrowing and lending obligation. Restricting deployment avenues for liquid funds may result in lower liquidity in these key markets as funds move into safer assets.

In summary, the primary rationale for investing in liquid funds—earning short-term interest rates with low volatility—is not changed by the change in valuation norms. Mutual funds will adapt to the new guidelines and liquid funds would continue to provide returns in line with those prevailing in the money markets.

Source: http://www.livemint.com/2012/02/13211552/Liquid-funds-to-give-returns-i.html