Large liquid fund outflows not as worrisome as posed by headline numbers

Assets under management (AUM) of the mutual fund industry stood at Rs 22.06 lakh crore as at September-end, down 12.5 percent from August, as per data released by the Association of Mutual Funds of India (AMFI). The significant fall of Rs 3.16 lakh crore on a month-on-month basis was on the back of huge outflows from liquid funds.

Despite market volatility and the credit event, inflows of Rs 11,172 crore in equity funds is very encouraging. Equity investments through systematic investment plans (SIPs), which tends to be relatively sticky, continued to show an improving trend with Rs 7,727 crore of SIP funds mobilised in September. Equity flows are holding up well, but the same can’t be extrapolated for future months if the sell-off in equities continues.

Since liquid funds have been at the centre of the recent fall in both equity as well as fixed income markets, we delved deeper into the numbers. While the headline outflow number from liquid funds is eye-catching, digging deeper doesn’t paint such a gloomy picture. We decipher the monthly flows of liquid funds and understand the repercussions of the same for non-banking financial companies (NBFCs) and system-level liquidity.

Liquid or money market funds saw outflows to the tune of Rs 2.11 lakh crore in September as compared to inflows of Rs 1.71 lakh crore in August.

The huge pullout from liquid funds was mainly triggered by a sharp de-rating of commercial paper (CPs) of IL&FS group companies by rating agencies. The rating downgrade forced MFs with exposure to IL&FS group companies to mark down their net asset value (NAV). The credit event increased risk aversion among investors leading to huge redemption in liquid fund units.

While this narrative holds true to some extent, seasonality played a huge role.

Fund houses generally see redemptions around mid-September as corporates, who are active investors in liquid funds, tend to redeem their liquid investments to meet advance tax payment deadlines.

Banks are one of the largest investors in money market funds. Banking system liquidity was in deficit mode in September, which implies that banks were borrowing from the Reserve Bank. This could be another reason for the redemption pressure faced by liquid schemes. Banks could have withdrawn their liquid investments before borrowing from RBI at the repo rate.

Against this backdrop, it won’t be correct to compare monthly numbers.

Past data indicates that there was an outflow of Rs 1,38,525 crore from liquid funds in December last year. Since we can’t compare numbers on an absolute basis due to seasonality, we compare outflow as a percentage of liquid AUM at the beginning of the month. In December, there was an outflow of around 32 percent of AUM. Given this fact, liquid outflow in September at 35 percent of liquid AUM is no doubt slightly higher than normal, but by no means a precarious situation.

Overall, we feel newsflow around withdrawals from liquid funds is blown out of proportion. There was a domino effect of IL&FS episode on liquid fund withdrawals, but only to a limited extent. A large chunk of outflows can be attributed to September-end phenomenon.

What is the key takeaway from the monthly numbers of liquid funds?

As recent as April, debt and liquid mutual funds gorged commercial papers (CPs) issued by NBFCs. The huge redemption pressure faced by MFs last month raised concerns about how NBFCs will meet their funding needs.

Now that we know that last month’s huge liquid outflow was an aberration caused by July-September quarter-end withdrawals, the moot question is can we expect normalcy to be restored in the funding market. The answer is slightly tricky.

MFs will continue to be extremely selective while lending to NBFCs. While large NBFCs with strong parentage should be able to easily place their CPs with MFs, the smaller ones will face a challenge.

We see limited demand for NBFC papers from MFs in the next 3-6 months as risk aversion of MFs tends to linger on for some time. We have in the past seen that MFs behaviour is akin to a flock of birds that takes comfort in each other’s company and fly away at the slightest sound of risk.

Having burnt their fingers after IL&FS episode, institutional investors will prefer liquid schemes with high quality papers. MFs too won’t rush to shore up their liquid AUM to stay ahead in the league tables since they earn very low fees on liquid schemes.

In the past, we have seen that MFs go into hibernation following a credit event, but do make a comeback. MF funding cannot be a perennial logjam but there is some time to go before MF gains confidence again. In the intermittent period, funding side pain will be inevitable for many NBFCs highly reliant on MFs.

Since the start of October, banking system liquidity has moved from deficit to surplus mode. Banks are now parking excess funds (between Rs 25,000 -40,000 crore) with RBI as against borrowing over Rs 1,00,000 crore from the central bank last month. We can expect inflows from banks to liquid schemes to resume and easier liquidity in money markets in October. While liquid flows will stabilise, the after-effects of the past month events will continue to loiter in the funding market.