The Securities and Exchange Board of India (Sebi) is planning to tighten the valuation norms for liquid funds. Liquid funds, as the name suggests, allow quick entry and exit to the investors and typically invest in money market instruments such as certificate of deposits, commercial paper and treasury bills.
To begin with, the regulator is planning to impose marked to market (MTM) requirements for instruments with a residual maturity period of 60 days and more. Eventually, Sebi wants all instruments irrespective of their tenure and type to be quoted on market rates and net asset value (NAV) calculated accordingly, according to people familiar with the developments. The move was earlier discussed by the mutual fund advisory committee
Fund houses are already gearing up for the change. “We have already got feelers from Sebi. We are expecting an official communication soon,” said a chief operations officer of a private sector fund house. The official added, “Sebi feels amortising does not adequately reflect the market value and could lead to systemic risks.”
"Sebi is considering applying MTM valuation for bonds with tenure of over 60 days. The idea is to prevent a situation like 2008,” said head of fixed income at a domestic mutual fund. Valuation committee of Association of mutual funds of India (AMFI) is expected to make a final recommendation on this issue,” he added.
The MTM valuation for money market and liquid instruments was introduced in July 2010 to avoid a repeat of the liquidity crisis in 2008, following the collapse of Lehman Brothers. However, this was limited to instruments with residual maturity of 91 days or more. As a result of this rule, implemented in July 2010, many fund houses booked heavy losses in FY11. For instruments of shorter tenure, fund houses follow the amortization method, where the returns on the instrument are prorated over the tenure of the instrument.
Arjun Parthasarathy, a fixed income expert and founder of investorsareidiots.com said the move to extend the MTM to instruments of shorter tenure will be welcome, “MTM reduces systemic risk. Without it, Funds are giving an implicit guarantee to the investors of a certain rate of return. But, unlike banks, they do not have the capital backing”
Corporates and banks have been using liquid funds as a cash management tool, since they are guaranteed of 3- 4 per cent returns. Due to the amortisation method used now, they do not experience volatility in the portfolio up to 90 days. But, this is an illusion created by the amortization method, which could get exposed in extreme events like the Lehman collapse, experts said.
According to Parthasarathy the new rule, if implemented, will bring volatility in the liquid fund NAVs. “Returns on liquid funds will take a hit and the corporate money will look for other options bringing down the assets under management,” he added.
RBI and Sebi have repeatedly expressed concerns about banks and corporates round tripping investments using liquid funds. Fund houses have lost significant money in liquid funds since RBI capped banks’ investments in liquid funds at 10 per cent of their networth in May last year.
According to AMFI, assets under management of liquid and money market schemes nearly halved to Rs 1.2 lakh crore or 20 per cent of the industry, in December 2011. At the end of April 2011, liquid funds managed Rs 2.2 lakh crore, accounting for 28 per cent of the industry.
