Liquid funds better for short-term investment

The recent fiasco of Non-Banking Financial Companies (NBFC) facing liquidity issues and the bankruptcy of Infrastructure lending major IL&FS has created ripples in the debt markets.

The rationale to raise short-term liquidity to drive business growth by these companies has come under lens. Moreover, the losing investor confidence has created a dent in further fund raising by these companies which resulted in stunted growth.

The short-term lending for these companies has been largely driven by the commercial paper (CP) which was being funded by many mutual fund (MF) houses through their various offerings of liquid category of funds.

The debt market is vast consisting of securities that have maturities ranging from as low as overnight (less than a day) and going up to as long as 30 years. The low tenure of a security to maturity enables them to be more secure as they would be less sensitive to any changes especially in the interest rate fluctuations.

Liquid funds invest in avenues that of debt and money-market instruments to generate regular returns at low-risk. These funds predominantly participate in securities or instruments with maturities less than 91-days.

Investors typically use these funds to retain the surplus for a short to very short period of time while enjoying better return than their savings account.

Though no investment is risk-free, the general assumption of individual investors about the liquid funds is that they are relatively safer, highly liquid and most importantly assume that the fund values or Net Asset Value (NAV) are not subjected to negative correction.

But, in recent months, the myth was thoroughly broken with NAVs taking a hit and going negative. Investors in these funds have experienced negative returns, though for a brief period.

Investors assumed that due to the nature of holdings, they are typically immune to the interest rate fluctuations as most of these funds have a predictable deviation against the prevailing interest rates.

But the recent solvency issues of some of the companies have rattled the nerve of the credit markets creating sudden tightness in liquidity leading. The subsequent investor panic has ensued further aggravation for these funds with the redemption pressure leaving losses for the investors for a brief period.

The current situations have resulted the regulator to bring some changes in the way the liquid funds are structured. Securities Exchange Board of India (SEBI) has allowed the fund managers to ‘side-pocket’, that helps them to segregate the riskier assets from other investments and cash holdings.

To explain further by invoking this, the money invested in liquid funds of the stressed assets gets locked till the funds recover the money from the company. Investors, however, could redeem the rest of their money thus containing the risk of negative returns to the fund.

As the affected assets or paper/debt is separated from the overall portfolio, two different sets of NAVs are provided for the fund where the subscriptions for the stressed/toxic or defaulted fund are closed while investors could continue to invest or divest their investment from the healthy or clear fund.

This is especially useful to the retail investor where the redemption of institutional investors is honored ahead of the retail ones, thus getting stuck with the toxic asset or negative returns.

But, would this help resolve the actual problem or plug the hold in the way. A counter argument is that it could lead to taking advantage by the fund managers to take riskier bets. The regulator is also considering it to restrict the usage of this practice only on exceptional cases of default.

Moreover, though not notified at this point of time, the big-brother wants to introduce the clearance of trustees by the fund manager before taking any such bets and monitor the performance of the funds by the board.

So, have the liquid funds lost the sheen? The answer may not be straight. They still offer better choices for short term investment, but the recent corporate events and the response of credit agencies have come to fore. This has led to marking a price over the liquid funds by the investors and thus tread with caution. (The author is a co-founder of “Wealcoity”, a wealth management firm and could be reached at [email protected])