Increased volatility of returns or slightly lower returns should not make you take increased risk, in search of higher returns.
On June 30, three changes are being implemented that will change the way your liquid funds perform. In 2019, the Securities Exchange Board of India (SEBI) took many steps to tighten the regulations of debt funds, make them more transparent and bring down the risk levels. But, due to the onset of coronavirus and the lockdown that followed, the effective dates were pushed back to June 30.
Liquid funds become more liquid
Your liquid fund shall hold at least 20 percent of its net assets in liquid assets. These include cash, government securities, treasury-bills and repo on government securities. If these holdings fall below 20 per cent, the fund house will have to take necessary steps to meet the requirement before making any further investments, SEBI says.
Holding a significant chunk in liquid assets ensures that, when faced with large and sudden redemptions, liquid funds can generate enough cash. In the wake of default on bonds issued by Infrastructure Leasing & Financial Services group companies in 2018 and the volatility in debt markets, SEBI felt the need to maintain a certain share of the portfolio of liquid funds into ‘liquid assets’.
Kumaresh Ramakrishnan, CIO - fixed income, PGIM India Mutual Fund, says, “As liquid funds invest more money in treasury bills and other liquid assets, there is a possibility of return going down slightly. However, the impact will be marginal as the gap between the rate of return available on treasury bills, and good quality commercial paper has already come down due to increased liquidity in the system.”
Mark to market valuation
Your liquid fund’s net asset value gets more realistic, effective from June 30. SEBI has also asked mutual funds to do away with the amortisation-based valuation, and irrespective of residual maturity, all money market and debt securities shall be valued on mark to market basis. The valuation of the underlying securities will reflect the valuations given out by the valuation agencies, as they happen for all other types of debt funds. This is a far more realistic way of valuing the debt securities as opposed to the amortisation method, where the accrued interest component was added to the issue price. Under the amortisation method, the security’s price moves up in a steady line till maturity, giving a false sense of security and oblivious to its realistic value in the market.
Lakshmi Iyer, CIO - debt & head products, Kotak Mutual Fund, says, “Mark to market valuations of all bonds held in the liquid fund portfolio will lead to a slight increase in volatility in net asset value on daily basis.” Investors with a seven-day investment timeframe should be prepared to stomach it, she adds.
Kumaresh also says that the impact would be minimal. “Investors have been investing for minimum seven days given the introduction of exit loads on investments in liquid funds. Fund houses too have reduced the average maturity of the portfolio to contain the volatility,” he says.
Revised sector limit for all bond funds
This concerns all debt funds, and not just your liquid funds. Effective June 30, debt funds can invest only up to 20 percent in a single sector, as against 25 percent earlier. Additional exposure towards housing finance companies (HFCs) in the financial services sector has been capped at 10 percent as against 15 percent earlier. However the overall exposure in HFCs shall not exceed the sector exposure limit of 20 percent of the net assets of the scheme.
“As the sectoral exposure is capped at 20 percent from 25 per cent earlier, the fund managers may choose to allocate that money to bonds issued by banks or public sector undertakings or public finance institutions along with government securities. This will enhance the demand for these bonds,” says Kumaresh.
The flight to safety will also work in favour of fund managers staying well below sectoral limits and sticking to sovereign backed bonds.
What should you do?
Just because your liquid fund gets a bit more volatile, this is a good thing. Joydeep Sen, the founder of wiseinvestor.in, says that investors should not run away from liquid funds as the only so-called safer option to a liquid fund is an overnight fund, and this one offers far less returns for avoiding the interest rate risk.
“Make sure you invest with a minimum two weeks investment time frame in liquid funds,” he says.
According to Value Research, over three months ended June 29 liquid funds and overnight funds gave 1.06 and 0.71 percent returns, respectively.
You have to be careful while investing in liquid funds around the monetary policy announcements. Vikram Dalal, the founder of Synergee Capital Services, says, “Off late, the frequency and the quantum of changes in policy rates both have gone up.”
Increased volatility of returns or slightly lower returns should not make you take increased risk, in search of higher returns. Avoid investing in short term bond funds or gilt funds for short term.
“Individual investors should use liquid funds as a source scheme while transferring money to equity funds using systematic transfer plan. Liquid funds should offer around 4 to 5 per cent returns going forward, which is attractive,” Vikram Dalal adds.