'Move to allow amortization of some instruments a step in right direction, but tad disappointing'

Arvind Chari

SEBI has announced that fixed income instruments of only less than 30 days can be valued on amortization basis and all other instruments will have to be marked-to-market on a daily basis. This is against the existing valuation principle of amortizing instruments below 60 days maturity.

The concept of amortization suggests that the fund can value the securities by accruing the coupon interest rate daily instead of accounting for changes in the market yields of those instruments.

A step in the right direction, but we still feel the SEBI move to allow amortization of instruments of up to 30 days maturity is a tad disappointing. Although it is as per their roadmap and blue print but the time was now apt to move to full Mark-To-Market of all securities.

SEBI has steadfastly improved investor protection in debt funds over the years and we believe that even this rule will be changed to move to full MTM in sometime.

Liquid Funds have come a long way on this issue with maturity being capped at 91 days to reduce market risks and then moving to fair valuation of securities in 2012 but allowing for amortization for instruments below 90 days then to 60 days and now for only on instruments below 30 days.

This practice of amortization though may have left us with some unintended consequences.

Allowing amortization has distorted fund management: Under the earlier practice, issuers were forced to issue below 60-day instruments leading to higher rollovers and transactions. Also, liquid funds were shy to own 90 day assets even if the rates were attractive so as to not to have to MTM those papers. Will the new rule force investments in less than 30 day instruments? If the yield difference between a 30 day instrument and 90 day widens, and if funds hold the lower yielding 30 day paper to have no NAV volatility, Is the investor interest being served by avoiding volatility or being compromised?

Amortization allows fund manager to be complacent and hide true market value: Given the cases of defaults in liquid funds, one needs to ask whether those securities prior to default were being amortized and thus not reflecting its deterioration in its value. For eg, in the case of ILFS, market yields had moved higher prior to default, did liquid fund NAVs reflect that increase in yields/fall in prices or were they continued to be valued on amortization basis.

Does Amortization force liquid funds to borrow to meet redemptions: Many Liquid Funds today show net borrowing positions on their fact sheet. They may be doing this to protect the current portfolio yield/return instead of selling assets and realizing the true MTM.

Amortized NAVs are misleading: Liquid Fund are not and should not be treated as bank deposits. Thus straight-line NAVs like that of returns from bank deposit is misleading and lulls investors and fund managers into complacency. In the event of a tight liquidity or a credit event, the funds NAV suddenly reflects the true value as against in a fully daily MTM portfolio, the NAVs would have already represented the increase in yields.

Higher Share of illiquid assets needs full MTM: An average liquid fund today owns more than 60% of its assets in Commercial Papers and a good share of that is in non-AAA assets. We know that these assets are illiquid as compared to Treasury Bills and Bank CDs. Given this portfolio characteristic of lower credit profile and lower liquidity, full MTM is needed to ensure that declared NAVs are ‘Real’ and reflects true and transactable fair value.

The common remark against a move to full MTM is that it would increase the volatility in the NAV and large corporate investors would move to bank deposits.

For a 30, 60 or 90 days instrument the change in price on a change in yield is very small. But now, since any instrument above 30 days will be MTM, there will be some increase in the volatility of a fund’s NAV. Investors, I believe, will get used to it and will only increase on better transparency and fair valuation. As the above pointers indicate, investor interest is actually getting compromised by following amortization. For investors who do not want any credit or market risks, they are anyway better off in fixed deposits or overnight funds.

The issues of credit and liquidity risk in a Liquid Fund is relevant today than ever before. The investment objective of a Liquid Fund is to keep the portfolio Safe, Liquid and then try to earn returns which are slightly higher than bank savings, current and short term fixed deposits. Liquid Funds are positioned as Safe, Liquid and low market risk products.

Recent events of defaults in the last 4 years in liquid funds, suggests that Return seeking has taken precedence over Safety and Liquidity. Today, an average liquid fund has more than 60% in Commercial papers and a good share of that is in non-AAA assets. This has increased the liquidity and the credit risk of Liquid Funds.

As more retail investors come in to mutual fund, Liquid Funds will become the main investment product to park short term cash surplus and to use it as a vehicle to switch / transfer money periodically into an equity fund. Liquid Funds are not meant to be excess return generating, wealth creating products. These investors are not prepared to see defaults on their liquid fund investments.

To be True-To-Label, there is a need to have liquid funds which do not take any credit risk and just focus on keeping your money safe and liquid.

SEBI categorises liquid, money market and debt fund based on duration. (on maturity of the instrument/portfolio). There is an urgent case to categorize it on credit risk as well.

There needs to be a category of debt funds which takes no credit risk. If not for all categories, there needs to be a Zero Credit Risk Liquid Fund, Short Term Fund and Income Fund. Zero Credit Risk could mean allowing investments in Government securities, Treasury Bills and PSUs to make it palatable to the government and regulators.