SEBI, in June 2019, made a few changes to investment guidelines and valuation of securities in debt mutual funds. These changes enhance credit and liquidity profile of the liquid funds. At the same time, these changes can make liquid funds a bit volatile.
Let’s try to understand the new SEBI rules.
#1 Liquid funds are now required to hold 20% in liquid assets
Liquid funds to hold 20% in assets such as Cash, Government Securities, T-bills and Repo on Government Securities. This improves credit and liquidity profile of at least some of the liquid funds to an extent.
#2 Liquid funds will have exit loads now.
A graded exit load shall be levied on investors of liquid schemes who exit the scheme up to a period of 7 days.
Therefore, if you were thinking of putting money in liquid funds for a couple of days (if that ever made sense to you), then be prepared to be charged a penalty. SEBI has not specified the quantum of exit load. However, you can expect it to be very small.
Retail investors have little to worry. In fact, this move helps AMCs more.
#3 Liquid funds will be a bit volatile. Amortization not allowed now
Earlier, SEBI used to allow bonds with a remaining maturity of up to 90 days to be amortized. Then, the tenure was reduced to 60 days, then to 30 days (in March 2019) and now the amortization has been done away with completely.
What is Amortization?
Let’s say you purchase a bond for Rs 98, and it matures at Rs 100 in 90 days (zero-coupon bonds). By the way, treasury bills work in this fashion too. The bond is traded on the market and you will always have market value. Let’s say SEBI allowed amortization for bonds maturing in 90 days.
The value of your bond will increase from 98 to 100 in 90 days. You will get your money back on the date of maturity. With amortization allowed, you could simply increase its value by Rs 2/90 (Rs 0.022) every day. The fund manager (or the investor) does not have to worry about the rating downgrade, market fluctuations, interest rate movement, fair value or anything else. The bond value (and concomitantly the fund NAV) can inch up in a straight line. Everything is hunky-dory until such time there is a default.
With provision for amortization, liquid fund NAV could follow a smooth path. And this is what the biggest liquid fund investors want.
Corporate Treasuries/businesses park a lot of money into liquid funds. After all, they earn 0% in their current accounts. Such investors can park money for a few days or even overnight. Given the quantum of their investments, even a couple of days of investments means lakhs of rupees. A Rs 1,000 crore investment can earn about Rs 19-20 lacs per day in a liquid fund (assuming 7% return).
Now that liquid funds must follow mark-to-market approach to their investments (with amortization done away with), such investors would be cautious.
For the corporate treasuries, they don’t want to see a downtick in their portfolios, which now is a possibility. Earlier, it could have happened only in case of credit default. Even though the liquid funds carry very limited interest rate risk and typically the credit rating of the investments is also high, the quantum of investment and very short investment horizon makes it tricky for the biggest investors. Adverse volatility for a few days and a few heads will roll. It is possible that businesses or corporate investors may now prefer to invest in overnight funds.
Even though retail investors like you and me can also invest in liquid funds for a few days, how many of us do that? At least, I don’t. Even if the money was needed after a few days, I would rather keep the money in my bank account. Of course, my investment amount is low too. Therefore, this move does not really affect us. In fact, it is a good move because it keeps the fund asset prices closer to reality.
This article from Deepak Shenoy has addressed this topic in a brilliant fashion. This is a must-read article. I learned a lot myself.
#4 Liquid funds and overnight funds not allowed to invest in short term deposits, debt or money market instruments having structured obligations and with credit enhancements
Such structures could be a loan that is backed by a guarantee from the promoter group entity and backed by shares of the promoter company. Now, liquid and overnight funds can’t make such investments.
Other variants of debt mutual funds can have up to 10% of the portfolio in such securities. Any debt security with credit enhancement backed by equities must provide security cover of at least 4 times.
Additionally, exposure to a corporate group is capped at 5%.
The sectoral cap has been reduced from 25% to 20%. For investment in Housing Finance companies (HFCs), there is an additional exposure of 15%.
#5 Mutual fund schemes must now invest only in listed Non-convertible debentures and listed commercial papers
This shall be done in a phased manner.
SEBI Chairman made an interesting comment recently, “Mutual funds are not banks and they are investing and not lending.” Some of the recent troubles with debt mutual funds can be attributed to a few AMCs not adhering to this basic principle.
The deals for Loans against shares (with limited recourse in some cases) were struck with powerful promoters. Essentially, the mutual funds indulged in primary lending. When there was default, the AMCs agreed with the promoter not to enforce security (sell shares). As I understand, the fund houses won’t be able to do such deals in the future.
In my opinion, all the moves are retail investor friendly and are a step in the right direction.