Short-term debt fund returns may turn volatile

Markets regulator Securities and Exchange Board of India (Sebi) in a board meeting, earlier this month, announced changes in the valuation of debt securities that will mostly impact the portfolio of liquid funds.

Simply put, debt instruments with over 30 days to maturity will now be valued on a mark-to-market basis. This move is anticipated to make the net asset values (NAV) of short-term debt funds like liquid funds more volatile. DNA Money spoke to fund industry experts to understand how this will impact liquid and some money market funds and what should investors do.

Constant change

With the latest changes, debt securities when marked to market will see their values going up or down from one day to the next. This will be translated into NAVs of funds too.

The main impact will be in liquid funds, which have generated up to 7.5% return in last one year. Liquid funds invest in short-term money market instruments. Liquid funds generally have institutional investors who are looking to invest for short term and prefer lower volatility in returns.

Liquid funds can generally invest in papers with maturity up to 91 days. However, securities above 60 days had to be mark-to-market (MTM).

"In liquid funds, the fund usually invests bulk of the assets in less than or equal to 60 days papers, so that the asset could be amortized and there was no daily MTM impact. This would generally reduce daily volatility in returns. With the change of norms from more than 60 days MTM to more than 30 days MTM, liquid funds will likely buy more papers of up to 30 days (than up to 60 days earlier). Since 30-days papers will generally have a lower yield than 60-day papers, the overall liquid fund returns are likely to go lower," said Avnish Jain, head- fixed income, Canara Robeco MF.

Non-liquid fund categories will not be impacted as generally bulk of the debt investments are valued (mark-to-market) on a daily basis.

Some experts feel that it would be too early to say liquid fund returns would be negatively impacted. Lav Kumar, head - product and business development, LIC MF said: "Post the Sebi move, returns will now fluctuate in a way that has not happened in the past. But we should not make a hasty decision in terms of saying returns will fall. We should wait to see how actual returns pan out."

Echoing similar sentiment, Alok Singh, CIO, BOI AXA MF says the change in MTM limit will mean that liquid fund portfolios will be valued more fairly. "Also, due to this the NAV volatility may increase to some extent but we don't think that this will change the return profile of liquid funds," he added.

Liquid logic

Given that the average maturities of liquid funds may reduce, it is being said that investor returns too could go down marginally in the liquid category. Explaining this, Lakshmi Iyer, CIO (debt) and head products, Kotak Mahindra AMC said this change would largely impact only liquid category funds, as the non-liquid category funds anyway don't have an investment tenor of one-day to a week. "It's liquid category that investors tend to deploy even their one-day day requirement funds," she said.

Other categories are insulated from this change. "Non-liquid category investors ranging from ultra short, low duration, short term, etc, typically have investments horizons ranging from, say, three to six moths at the lower end to 12-36 months at the higher end. Hence they are used to a relatively higher volatility in comparison to liquid funds," Iyer said.

For example, ultra short-duration funds and low duration funds are required to maintain a Macaulay duration between three and six months and six and 12 months respectively. Thus, for most securities in their portfolio the residual maturity will lie within the same range, hence, will not fall under the purview of the new valuation policy.

However, Jason Monteiro, assistant vice-president - mutual fund research and content, Prabhudas Lilladher is clear that the revised valuation policy will certainly impact liquid funds and some money market funds that maintain a considerable exposure to debt instruments with a residual maturity of under 60 days.

"Moving to MTM valuations for any instrument above 30 days will certainly increase the volatility of the NAV for liquid funds, as compared to amortisation-based valuations. However, investors should realise that for the affected instruments with a maturity between 30-60 days, the price sensitivity to a change in yield is very small. Liquid funds, as a category, aim to remove MTM risks from their portfolio. Presently, almost all the 37-odd liquid fund schemes have an average maturity under 60 days. About 10 schemes have a average maturity under 30 days. This suggests that a high proportion of the liquid fund assets are allocated to securities with a residual maturity of under 60 days, leading to negligible MTM volatility," said Monteiro.

It remains to be seen how fund managers react. Their action will hold the key to liquid fund returns. "In order to reduce MTM risks for liquid funds under the new valuation norms, it needs to be seen if fund managers will shift a large portion of their assets to securities with less than 30 days to maturity. If this happens, it may lead to a lower return for investors, albeit with negligible MTM volatility as well. At the same time, investors need to bear in mind that the MTM volatility is not very high in low duration securities, specifically those with a maturity under 60 days," added Monteiro.

Overnight optimism

This policy may also lead fund managers to evolve a stringent process to avoid poor quality securities in their portfolios. Such securities were earlier amortized, hiding the true valuation. If the MTM model was followed for these securities, it would have led to higher volatility. Thus, the new valuation policy is a step in the right direction to improve transparency and accountability of mutual funds.

Investors who wish to invest for a few days or those who do not wish to bear MTM risks, may opt for overnight funds. Overnight funds invest in securities having a maturity of 1-day. They invest in collateralised borrowing and lending obligations (CBLO) and repo/reverse repo instruments that mature the next day. Hence, this debt category is free from interest rate risk or credit risk, unlike other debt schemes like liquid funds.

If investors are looking to park their money for a period of two to three months, with low volatility, then liquid funds are still a good option. "Liquid fund returns are likely to be still better than overnight rates, but depending on the holding period of an investor, they can look at slightly higher duration funds like Ultra short-term fund/ Low duration funds," said Jain of Canara Robeco MF.

WHAT THE SEBI MOVE MEANS

• Debt instruments with over 30-days maturity will now be valued on a mark-to-market basis  
   
• This could make NAV of liquid funds more volatile as they have invest in short-term money market instruments
   
• If fund managers shift assets to securities with maturity less than 30-day, returns could fall, but volatility will be lower