The IL&FS defaults and the aftermath of it, which roiled the debt markets over the last six months, led to a flurry of mark-downs in debt mutual fund schemes net asset values (NAVs) including liquid funds. Not only did this stop the proposed ‘Debt Fund Sahi Hai’ campaign from taking off, it also led the Securities and Exchange Board of India (Sebi) to revisit the regulations and issue new guidelines. It instituted working groups to look into the various practices and suggest appropriate changes.
In its board meeting held in June, the recommendations of the working group were discussed, and the markets regulator tweaked the risk management framework governing of liquid funds and prudential norms governing investments in debt and money-market instruments.
The regulator has done away with the valuation of debt and money market instruments which were applicable to securities with a residual 30-day maturity forming part of liquid funds. One of the major benefits of liquid funds was the amortization norm which made them less volatile. With all securities to be marked to market, it will make the scheme returns more volatile in the short term.
Liquid funds were considered to be least risky of categories of mutual funds to invest in. To reduce the risk of these further, liquid funds shall be required to hold at 20 per cent of their assets in liquid assets such as cash, government securities, T-bills and repo on government securities. The regulator has reduced the sectoral cap from 25 per cent to 20 per cent, and also cut down on the exposure of debt instruments of housing finance companies from 10 per cent to 5 per cent.
Apart from the above, they shall not be permitted to invest in short-term deposits, debt and money-market instruments having structured obligations or credit enhancements. While this will certainly reduce the risk in these funds, it shall also affect the returns generated by this fund in addition to the volatility discussed above.
Liquid funds featuring in the framework of working capital management undertaken by businesses would have to rework their allocation to these funds in light of the exit load proposed by Sebi. The regulator has proposed that a graded exit load shall be levied on investors of liquid schemes who exit the scheme up to a period of seven days.
Apart from liquid funds, the regulator has also taken decisions which shall impact other fund categories. To deal with the issue of illiquidity of papers in the debt markets thereby impacting their valuation, mutual fund schemes have been mandated to invest only in listed non-convertible debentures (NCDs) and commercial papers. The above shall be done in a phased manner and the regulator shall come out with further regulations on the same. This will help in price discovery of papers and provide correct valuations of papers held by debt funds.
The recent case of Essel wherein the fund houses were caught off guard in their holding of collateral securities, has also been noted by the regulator. To avoid further such instances, the regulator has directed fund houses to keep a security cover of atleast four times for investment by mutual fund schemes in debt securities having credit enhancements backed by equities directly or indirectly.
The implementation process to incorporate the above decision is awaited and mutual funds will come out with requisite communications on the same. While the reactive nature of the regulator has been noted by one and all, the impact of the above decisions shall be felt in the coming months post implementation of the above decisions. However, in the long term, prudential and risk mitigation norms shall certainly benefit the investors and help the regulator to carry out its duty of protecting investors best interest.
The above changes should not desist the investors from shifting from liquid funds since mandate of this category and its role in asset allocation does not change. Since liquid funds form part of the portfolios for very short-term investments, a lower percentage of returns should not lead to change allocation since the absolute value does not reduce substantially when returns are seen at a portfolio level. However, businesses will have to rework their return expectations and working capital management in light of the exit loads. Overnight funds should form part of these business since they still remain exit load free.
(Dhruv Rawani is the Founder of GoalSIL.com. The views expressed are personal)