Talking Point. Are liquid funds losing their sheen?

With rates on bank deposits falling sharply over the past year, investing a portion of your surplus in liquid funds, which have been delivering better returns, is a sound idea.

But after raking in 8-9 per cent gains in the past couple of years, liquid funds have seen a moderation in returns over the past year.

In the near to medium term, this trend is likely to continue, given the ample liquidity in the system. Investors parking money in liquid funds should take note of the lower post-tax returns, which can now be at par with savings deposit rates offered by a few banks.

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

As per SEBI regulations, non-traded securities that have residual maturity of up to 60 days do not have to be marked-to-market, with a certain exceptions to this rule. For listed securities (such as TBs and NCDs), mark-to-market valuation applies irrespective of the residual maturity.

Since a chunk of liquid funds’ investments are in securities with maturity of upto 60 days, these have to be valued on accrual basis.

Under this method, the interest of the underlying security is amortised over the tenure of the scrip and the daily interest is then added to the price.

This is what makes the NAV of a liquid fund less volatile. But this is also why returns from liquid funds lag those of ultra short-term and short-term debt funds.

Since liquid funds earn returns through accrual, rate movements on money market instruments matter the most. Thanks to the RBI’s decision to move towards a neutral liquidity regime, short-term rates continue to hug repo rate which is currently at 6.25 per cent. Even if the RBI does not lower its repo rate from hereon, the ample liquidity in the system (particularly post demonetisation) will keep the spreads of money market instruments over repo rate, narrow.

This will, in turn, impact the returns delivered by liquid funds as a category.

In 2016, liquid funds as a category have delivered 7.5 per cent returns, lower than the 8-9 per cent they delivered between 2011 and 2015.

This falling trend is expected to continue over the near to medium term, with returns possibly slipping to 6.5 levels.

The post-tax returns can hence now match rates that are offered by a few banks on their savings deposits (6 per cent). Remember, savings accounts score better on the tax front; interest up to ₹10,000 is exempt under Section 80TTA of the Income Tax Act.

If we assume 6.5 per cent return on liquid funds, post-tax returns work out to 5.8 per cent, 5.2 per cent and 4.5 per cent respectively for individuals in the 10, 20 and 30 per cent tax bracket.

While this is higher than the 4 per cent that most banks offer, banks such as YES Bank, Kotak Bank, IndusInd Bank, Lakshmi Vilas Bank and RBL Bank offer a higher 6 per cent interest on high-value deposits.

Hence some of these deposits can score over liquid funds in the near future, which investors need to watch out for. But remember, the current falling rate trend on short-term securities can reverse. Liquid funds can then, once again, turn attractive.

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