Mark-to-market valuation of bonds, a positive for investors in the long run

Over the last few months, the rules for marking to market the securities held by debt mutual funds have been modified. Before we discuss market regulator SEBI’s new rules, let’s put them in context. The NAVs (net asset values) of mutual funds are declared every working day. The value or price taken for the purpose of NAV computation is the market value of the securities in the portfolio of the scheme, i.e., the traded price at the Exchange. So far so good; the NAV of the day represents the market-traded value or price of the securities on that day. In other words, hypothetically, if the AMC (asset management company) were to liquidate the entire scheme, this is the approximate value that can be realized, subject to some impact cost.

Arriving at the realisable value

But if the secondary market is illiquid and the last traded day for a particular security was quite a while earlier, then what is the valuation? If the last traded day’s price is taken, which is old data, it does not represent the market price or saleable price of that day. There is another way for valuing debt instruments called ‘accrual’ or ‘amortisation,’ which takes into account the purchase price plus the accrued interest till that date. However, this value too does not represent market reality; if the AMC were to sell, the realisable value may be higher or lower than the accrual valuation. Hence, the way out is an estimate of the market value of that day, in accordance with the movement in the prices of liquid securities such as Government Bonds, movement of securities of similar description, any change in the credit spread (i.e. G-Sec yield plus mark-up) of that security, etc. But, who will do it? It has been assigned to neutral organizations – not the AMC itself, but rating agencies CRISIL and ICRA. These agencies declare the daily valuation yield of all debt securities. The valuation price is derived from the yield, as per the formula used in the market.

Coming to the SEBI rules, till a little while earlier, it was required that AMCs follow the valuation given by the agencies for debt securities of residual or remaining maturity of more than two months. It meant that debt securities with more than two months remaining maturity would more or less follow the market movement, as the valuation is as per the estimate given by the designated agencies. For securities with less than two month remaining maturity, valuation was on accrual/amortisation basis. It meant that schemes holding these securities, for e.g. Liquid Funds, would deliver stable returns as the movement in the underlying market is being ignored. It works fine in a blue sky scenario. If the fund faces significant redemption pressure, if securities have to be sold in the market and if the market is tanking, there would be a problem. In such cases, the hitherto unrecognized fall in prices, i.e., prices not considered for daily NAV valuation become a reality and the fund is jolted.