How the new valuation norms impact debt funds

Returns from liquid funds may moderate as fund managers are likely to reduce the maturity of their portfolios

The IL&FS crisis that rippled through our bond markets, impacting debt funds, has left investors in the lurch. As the entire saga unfolded, many debt funds, including liquid funds, witnessed a fall in their NAV (net asset value). As the event snowballed into a liquidity crisis for many NBFCs, a sharp rise in the yield of certain debt papers in the secondary market, and the ongoing concern over the liquidity issues at NBFCs have kept investors on tenterhooks.

To mitigate some of these issues and ensure that the valuation of the underlying securities in the funds’ portfolios are not too far from the prevailing market scenario, SEBI recently tweaked the valuation norms for money market and debt securities by mutual funds.

In effect, there are two main changes.

One, the residual maturity limit for amortisation-based valuation by mutual funds has been reduced from 60 to 30 days. Two, the difference between the reference price given by the valuation agencies and the valuation price considered by the fund, for securities having less than 30 days of residual maturity should be ±0.025 per cent. Let us break down these proposals.

How valuation works

For starters, it is important to note that SEBI’s proposals mainly impact liquid funds, as these funds invest in debt and money market securities with residual maturity of less than or equal to 91 days.

Currently, non-traded securities that have a residual maturity of up to 60 days do not have to be marked-to-market. These are valued on amortisation basis, i.e., it moves like a straight line, not fluctuating with market movements. For debt securities with a residual maturity of over 60 days, the mark-to-market valuation will apply. This is based on the valuation matrix prescribed by rating agencies for valuing corporate papers and mark-to-market gains/losses.

Now, as per SEBI’s proposals, non-traded securities that have a residual maturity of more than 30 days will have to be marked-to-market. Also, in case of securities with a maturity of less than 30 days, where amortisation-based valuation will apply, if such valuation varies by more than 0.025 per cent or 2.5 paise (which implies about 30 bps) from the price given by valuation agencies such as CRISIL and ICRA, the securities will be revalued based on such valuation. Earlier, the threshold for deviation was 10 paise for securities having a residual maturity of less than 60 days (implying 50-60 bps movement).

What this implies

Currently, for funds predominantly holding securities maturing in less than or equal to 60 days, there is less volatility in NAVs due to amortisation-based valuation. But this also implies that the price assumed for NAV calculation may be far from the market price of the underlying security. Hence, in crisis situations such as the IL&FS/DHFL episode, the NAV would not reflect the market conditions. This could result in a sharp fall in NAV if the fund manager is forced to sell the bond under question in the secondary market at a far lower price.

The SEBI’s proposals — to move the threshold to 30 days and factor in tighter deviations — will ensure that NAVs move more in tandem with market conditions.

Lower returns

Currently, most liquid funds have a residual maturity of 45-60 day, implying that these funds stock up on less than 60-day papers to make use of the amortisation-based valuation to minimise volatility in returns.

SEBI’s move would most likely result in maturity of liquid funds moving to 30 days or less, as funds would prefer to buy more of 30-day papers to follow amortisation-based valuation. This would lead to some moderation in the returns from liquid funds.

The RBI embarking on rate cuts is an added dampener on returns.

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