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SEBI Regulations On Liquid Funds
If we take a look at the current market situation, there is high stress and the crisis of liquidity of funds.
Even the investment avenues which are considered safer like liquid funds have been affected by the recent credit events in the fixed income market.
To refresh your memory, liquid funds are basically debt funds that invest in very short-term market instruments such as treasury bills, government securities and hold the least amount of risk.
The situation became worse after the recent non-banking company (NBFC) crisis which started in September 2018 after IL&FS group companies defaulted on payments.
These defaults made lenders more cautious about lending money to NBFC’s resulting in a credit squeeze.
To get matters worse, several other companies in which mutual funds had invested also defaulted on payments.
All these events had hurt the investors hard and thus to protect the interests of investors, the watchdog has to step in.
Based on the recommendation of the Mutual Fund Advisory Committee (MFAC), the Securities Exchange Board of India (SEBI) has now introduced various changes governing the debt funds to revive the confidence of investors in the debt mutual funds.
In this article, I will highlight the key changes made by SEBI in its 27th June 2019 board meeting.
The biggest proposed change is the way the debt funds value the underlying securities. From now on, the valuation of all assets will be entirely done on a mark-to-market basis.
This means that all the securities in the portfolio of the mutual funds will be shown at their present prevailing market value.
Previously, securities of more than 60 days were only to be mark-to-market. For those with lower tenure, the difference between the purchase price and redemption amount on maturity can be amortized over the period of the instrument.
Recently SEBI has reduced this time limit for the valuation of securities to 30 days.
The amortization of securities didn’t depict the true picture to the investors. Any deterioration in the value of troubled securities was not reflected in the Net Asset Value (NAV) of the bond as it wasn’t valued at market prices.
This limited the volatility of the fund and prevented NAV to present accurate realizable value.
With the introduction of the mark-to-market valuation method for the portfolio of liquid funds, SEBI has made these funds more transparent. Though the NAV of liquid funds has now become more volatile, the valuation will be more realistic.
Minimum Liquid Assets
Liquid funds are now required to hold at least 20% assets in cash and cash equivalents like government bonds, treasury bills, etc.
This will ensure sufficient liquidity of the fund at all times, particularly during the period of stress in the bond market when redemptions are high.
Mostly liquid funds were investing some amount in these liquid assets, but now with strict rules all funds will be forced to adhere to the limit.
Graded Exit Load On Liquid Funds
A scheme of graded exit load in been introduced on the investors of liquid funds who tends to exit the fund within 7 days of investing.
Many institutional investors used to park large funds in these liquid funds for a few days and moved out when better opportunities emerge.
With the exit load, the huge inflows and outflows of money will be minimized to some extent. These corporate investors will now tend to shift to overnight funds that invest in securities with one-day maturity.
No Structured Obligations
Liquid funds and overnight funds, from now on will not be permitted to invest in short term deposits, debt and money market instruments having structured obligations.
Liquid funds are not meant to invest in securities with structured obligations as these may not be that liquid. This direction will tend to improve the liquidity of the liquid and overnight funds.
Debt Papers With Credit Enhancements
Mutual funds tend to enter into an arrangement that typically involved a promoter guarantee or offer of shares as collateral or loan against shares. Such instruments generally offered high returns.
Recently, it came to the notice of SEBI that a few fund houses that gave loans against shares didn’t invoke the guarantee even the value of collateral tumbled. This was against the interest of investors as it limited the liquidity of the funds.
Now, for investment by mutual funds in such debt securities with credit enhancements backed by equities directly or indirectly will have to have a cover of at least 4 times. Further, the exposure to such instruments has been capped to 10% of the portfolio and 5% to a group.
Sector Cap Reduced
SEBI has further tightened the sector exposure of the liquid funds. Now, the exposure to a single sector will be limited to 20% as against 25% earlier. The additional exposure of 15% to housing finance companies is been reduced to 10%. This will reduce the concentration risks as the funds will be diversified among various sectors.
Clearly, all these changes have a positive effect on the liquid funds. These have made liquid funds more liquid, transparent, diversified and safer investment option.
With these norms, the investors are to gain some confidence in debt mutual funds. Though these stringent rules will make the fund more volatile and dilute the returns of the fund it surely will provide a less risky and cleaner portfolio for the investors.
The makeover of liquid funds provides the investors with a better proposition and comfort to invest their idle funds productively.
Happy Investing !
Disclaimer: The views expressed in this post are that of the author and not those of Groww