Mutual Funds

Why you need to keep a tab on liquid funds

Radhika Merwin | Updated on April 12, 2020

Steep rate cut by RBI, falling bond prices and fund outflows make them vulnerable

For investors in liquid and other short-term debt funds, the sudden, the interim fall in NAV of these funds about two weeks ago had caused anxiety.

While the performance of the funds has stabilised since then, there are still concerns on whether excess funds or surplus can be parked in these debt funds for the short term.

Returns in both debt and equity markets have been volatile over the past month owing to fund outflows. Foreign portfolio investors (FPIs) pulling out of corporate bonds also had a spill-over effect on the money market and other short-term debt instruments. In liquid and other ultra-short term debt funds, the sudden fall in NAV was led by a spike in yields across money market and debt papers; the thin volumes traded only compounded the problem. While returns have stabilised since then, such gyrations and volatility in the coming months cannot be ruled out, in view of the turmoil caused by Covid-19.

In normal situations, investorswilling to take the market risk, are advised to park a portion of their surplus in liquid funds to earn higher returns than what bank savings accounts offer.

At the current juncture, however, there are other factors that need to be noted.

One, cash in hand and excess surplus in easily accessible bank accounts are now the need of the hour. Amid the ongoing turmoil, it is imperative for people to set aside ample funds to meet exigencies.

Hence, invest in liquid funds only after you have set aside enough funds for emergency purposes.

Two, given that there could be knee-jerk movements in the yields of short- term debt papers, returns of your existing liquid funds could get impacted in a short time-frame. If you have a fairly longish view of over one year, don’t rush to redeem the money in these funds.

Three, given the RBI’s recent moves — cut in repo/reverse repo rate and targeted long-term repo (TLTRO) — yields could soften, lowering returns from liquid funds. With the repo rate at 4.4 per cent and the reverse repo rate at 4 per cent, liquid fund returns could be sub-5 per cent in the medium term.



Back to basics

Liquid funds primarily invest in money market instruments such as certificate of deposits (CD), treasury bills, commercial papers (CP) and term deposits, with a maturity of up to 91 days.

The relatively low duration of the portfolio (usually 45-60 days), vis-à-vis ultra-short-term or money market funds, mitigates the rate risk (though risk is higher than in overnight funds).

Currently, non-traded securities that have a residual maturity of up to 30 days do not have to be marked-to-market.

These are valued on amortisation basis, ie, not fluctuating with market movements.

For debt securities with a residual maturity of over 30 days, the mark-to-market valuation applies.

This implies that for debt funds predominantly holding securities maturing in less than or equal to 30 days, there is less volatility in NAVs.

Currently, many liquid funds have a residual maturity of little over 30 days (31-43 days), implying that these funds are more susceptible to market volatility, as a notable portion of the portfolio will have to be marked-to-market. But there are few other liquid funds that carry maturity of less than 30 days (20-29 days), minimising volatility in returns.

Why the volatility?

Liquid and other short-term debt funds had suffered a blip between mid-March and March 24, owing to a spike in yields on money market instruments (250 bps in certain July-September CDs, according to fund managers). The spike in yields, according to some fund managers, was on account of multiple reasons. One, FPIs pulling out from Indian debt market (about ₹60,000 crore in March alone) had a spill-over effect on money market instruments as well.

Given that volumes have been thin, it has only accentuated the problem. Two, redemption from liquid and other short-term funds is usually higher towards the end of the financial year.

The ongoing turmoil that has compounded the cash crunch faced by corporate firms and institutions, possibly led to higher withdrawals from funds, forcing funds to sell bonds at a lower price (thus rise in yields).

Three, there has been heightened risk-aversion among banks and other institutions, even towards high-quality debt papers. Banks, wary of treasury losses (on account of mark-to-market of investments) due to rising yields, do not seem to have much appetite even for government bonds.

All of this — resulting in a rise in yields of money market and other short-term bonds — impacted returns of liquid, money market and other low-duration and ultra-short-term debt funds.

For instance, between March 19 and March 25, returns of money market funds fell by about 33 bps (average maturity of up to a year) while that of ultra-short-duration funds (maturity of 3-6 months), fell by 23 bps.

Liquid funds that carry a lower maturity fell by 5 bps during this period (though the daily fall in NAV in some funds was more).

What now?

However, the returns of these funds have stabilised since then.

The RBI measures announced on March 27 have helped bond yields return to normalcy. The RBI announced TLTRO, where banks will have to deploy these funds in investment grade (BBB rated and above) corporate bonds, commercial paper, and non-convertible debentures.

Banks will not have to mark-to-market these investments.

Importantly, 50 per cent of the investments have to be made via the secondary market, which offers a much needed relief to mutual funds.

Other relevant points

Liquid funds have delivered 6.6-7.6 per cent annual returns over three-, five- and 10-year periods.

Returns over the past year have moderated substantially to about 5.6 per cent.

Going ahead, returns can moderate further to sub-5 per cent, owing to the RBI’s sharp cut in repo and reverse repo rate.

Two, some funds could follow a more aggressive strategy that can help generate relatively higher returns. Remember, prior to the 2019 regulations, non-traded securities that had a residual maturity of up to 60 days did not have to be marked-to-market. With the threshold moving to 30 days last year, many liquid funds moved their maturity to hover around 30 days or less, to follow amortisation-based valuation.

This was done to curb volatility in returns, though this led to some moderation in returns.

All debt papers across maturities had to be marked-to-market on April 1. But this has been postponed and now will come into effect from May 1. As funds move to this regime, volatility in returns will increase.

Also, some funds may follow a more aggressive strategy, carrying higher maturity (as there is no benefit of amortisation-based valuation for a particular maturity debt paper).

This could help in generating higher returns for investors with a higher risk profile.

Hence, watch out for funds’ performance and maturity profile over the coming months before investing.

Published on April 11, 2020

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