AMFI (Association of Mutual Funds of India) data for November 2016 shows that of total assets of Rs 16,500 billion, debt funds account for Rs 10,725billion or around 65% of total assets. Breaking down debt funds, Rs 2805 billion is in liquid funds that have an investment maturity cap of 91 days.
Liquid Funds are used as an alternative to short term Fixed Deposits and supplement to Savings Bank deposits. Investments of the fund are mainly into short term debt instruments like money market securities, short term corporate bonds and treasury bills. The maturity of instruments held in the fund’s portfolio ranges from one day to ninety one days.
Liquid funds are among the most preferred investments for corporates and high net worth individuals as they can park their surplus cash without compromising on liquidity and they can earn money market yields prevailing in the market.
Deregulation of interest rates on saving bank deposits by the RBI has made bank deposits more competitive. Post deregulation, banks have raised their savings bank deposit rates to compete with liquid funds. However Investors can earn money market rates from liquid funds, which are usually higher than deposit rates.
The short maturity of liquid funds makes it relatively less sensitive to interest rate fluctuation, compared to other debt funds. In India most of the fund houses are offering liquid funds without any lock in period and exit load.
When to invest in liquid funds
Liquid funds are ideal when there is a sudden inflow of money. The inflow can be either by bonus or from the maturity of investments. In such cases, investors can park their surplus money in liquid funds and can earn money market rates that are usually higher than savings bank deposit rates and wait for the right opportunity to invest elsewhere. Liquid funds are a good vehicle to keep cash for liquidity purposes.
Net Asset Value Calculation
The NAV of a liquid fund is calculated on the basis of accrued interest on securities held by the fund. In other words, given their short-term maturities, these securities are held until maturity. Hence, their NAV only sees a change to the extent of interest income accrued.
Illustration of NAV Calculation
The daily return of a liquid fund is usually made up of two components, accrual interest rate and expense ratio. In the above example we have assumed the fund YTM as 7.5% and expense ratio of 0.5%. The Net YTM, which is calculated by subtracting expense ratio from Fund YTM is 7% per annum. The Net YTM is divided by 365 i.e. the no. of days in a year, to arrive at daily accrual of the fund.
Liquid Plus Funds
Liquid plus funds are income funds that generally invest a portion of the net assets in debt securities having maturity period greater than 91 days going up to two to three years or more. A typical liquid-plus fund has similar investments like a liquid fund, but a percentage of the corpus is invested in securities with longer maturity period. The percentage of corpus invested in securities with longer maturity period will depend on the fund managers view on liquidity and RBI policy rates. Liquid Plus funds are suitable for those wishing to earn higher return with a longer holding period. There could be lock-in period for Liquid Plus funds. Liquid plus funds will have higher NAV volatility in times of stress in money markets given exposure to longer maturity money market securities or bonds.
Liquid Funds Cut-off time
If payment confirmation is received by fund house before 2:00 PM each day, the transaction will be executed on the same day and the application will be allotted NAV of T-1 day.
If payment confirmation is received by fund house after 2:00 PM, the transaction will be executed on the next business day.
SEBI Regulation on Valuation Norms
In 2012 SEBI has amended the norms to calculate NAV of a liquid funds. The threshold for mark to market in liquid fund is reduced from 91 days to 60 days.
This amendment means that in an event when debt and money market securities are not traded on a particular valuation day then valuation through amortization basis shall be restricted to securities having residual maturity of upto 60 days.
However, in the event when debt and money market securities having residual maturity above 60 days are not traded on a particular valuation day they shall be valued at benchmark yield/ matrix of spread over risk free benchmark yield obtained from agency(ies) entrusted for the said purpose by AMFI.
Risk in Liquid Funds
It is not correct to say that liquid fund does not carry any risk. They best way to avoid the risk in liquid funds is to understand it completely.
Risk on liquid fund will be best understood by analysing the 15th July 2013 action taken by RBI. On 15th July 2013 RBI took liquidity tightening measures like increasing MSF (Marginal Stability Facility) by 200 bps i.e. from 8.25% to 10.25%, placing restriction on LAF (Liquidity Adjustment Facility) and announcing open market sales of bonds to prevent INR volatility.
The liquidity tightening moves by the RBI took up money market securities yields by 300bps overnight. The rise in money market yields resulted in mark to market losses for Liquid Funds leading to NAV’s falling.
The following illustration shows the impact of rise in money market securities yields on liquid funds.
How does one avoid risk of such sharp rise in yields affecting liquid fund NAV’s. Liquid Fund investors should have a minimum period of at least fifteen days for investments in liquid funds in periods of market stress. A longer holding period will negate short term volatility in liquid funds. Liquid fund returns will normalize over a period given that the funds hold short maturity papers.
Money market yield volatility does not occur frequently. Hence at periods of stress such as global financial market volatility or currency volatility it is best to invest in liquid funds with a longer time frame. At normal times, liquid fund investments can be even less than a week.
Liquid funds that take higher credit risk by investing in lower rated money market securities can suffer if there is a credit event. Again in normal times such funds will generate higher returns than funds that stick to highly rated instruments but in stress conditions liquid funds diluting credit quality will underperform by a wide margin.