Why liquid fund returns are on a revival path

After clocking abysmal returns till the early part of this year, liquid mutual funds are showing signs of revival. One-year returns of these schemes have been around 7 per cent on an average in recent times after clocking a multi-year low of 6.5 per cent in February this year.

Liquid schemes are typically avenues where investors park emergency or idle cash and corporates look to make treasury gains. These are preferred over savings accounts and short-term deposits.

In the hey days of 2014, liquid funds clocked one-year returns of 9-10 per cent. But there has been considerable moderation over the past three-four years.

However, in the last six months, the performance of liquid funds has improved notably.

These funds invest only in debt securities with a residual maturity of less than or equal to 91 days. The lower maturity profile mitigates interest rate risk, along with credit risk (default risk).

The preferred choices are fixed maturity interest-paying instruments such as call money, CBLO, commercial papers (CP), non-convertible debentures (NCD), certificates of deposit (CD) and treasury bills (TBs).

Rate movements on short-term debt papers matter the most to these liquid funds. Thanks to the RBI’s decision to maintain liquidity in a neutral zone, short-term rates continue to hug the repo rate, which is currently at 6.5 per cent.

Systemic liquidity

However, the recent liquidity tightness in the system has resulted in an increase in the rates offered by short-term debt papers (above the repo rate), which, in turn, improved the performance of liquid funds.

Lakshmi Iyer, CIO (Debt) & Head - Products, Kotak Mutual Fund, says: “Short-term issuances continue to be healthy and the demand pipeline is also reasonably good. There could be some upward pressure in very short-term instruments due to some system liquidity tightness. But that could be a temporary phenomenon. System is neutral on liquidity and could herd to negative zone as we enter advance tax outflow period. Also, to the extent there will be currency intervention, the liquidity situation could get further aggravated.”

Such liquidity tightness would further widen the spreads of money market instruments over repo rate. This, in turn, will improve the return of liquid funds. “The key would be to see if the RBI announces any OMOs or any other measure to address this situation,” added Iyer.

Rising long-term yields

Interest rates in India remain at elevated levels. The weakening rupee and the rise in crude prices have resulted in the yield on 10-year government bonds moving up sharply in recent times.

Next rate hike

While the RBI hiked the rate in the June and August policies, the possibility of further hikes in the next policy has increased.

Any further hike in the repo rate will eventually benefit investors in liquid funds. However, the upside may be limited, which could reach up to 7.5 per cent in the near to medium term.

Over the last one year, liquid funds have significantly increased their exposure to CPs, which helped the funds record decent performances.

The rates of the CPs maturing in one month rose from 6.4 per cent to 7.5 per cent during this period. On the other hand, the repo rate increased 50 bps over last year.

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