Debt Funds: SEBI Moves To Reduce Liquid Fund ‘Subsidy’

This will largely be relevant for liquid funds which are the biggest investors in near-term instruments. The intent seems to be to increase the element of price discovery via the open market for the net asset of such funds. The norms have to be welcomed by both investors and fund managers for a variety of reasons, some of which are detailed below.

Liquid funds are less of investment products and more of cash management products. Many investors come here just with an overnight horizon. Thus, if there are no elements of ‘subsidy’ embedded in the product, by definition the return should be close to or at the overnight rate of interest. The Reserve Bank of India’s repo rate is a proxy for this, although the actual transacted average overnight rate in the market may vary somewhat from this from time to time. As a corollary, the higher the average returns are for liquid funds compared with the average overnight rate, the higher the element of subsidy in the return.

Having established this, it is important to ascertain who is paying this subsidy. Since not all of the fund is getting churned overnight, that is there are investors who are there for the longer-term as well, the fund manager in a liquid fund is able to buy longer than just overnight assets. The first element of subsidy is being paid by longer investors—that enable the manager to run longer assets that have better carry—to the overnight investors.

There is another element of subsidy as well, and one which is shared by all investors. The fund manager runs a valuation risk which can be defined as the gap between the reference price and valuation price. There is a tolerance threshold available till which the fund manager needn’t recognise the actual price of the security. However, this will get recognised and accordingly impact the NAV should the manager be forced to sell the security in the market.

Indeed, if the sale happens in a stress situation, then the impact may even tend to be higher as the market ‘rediscovers’ the actual price of the security. Now in the ordinary course of events, this subsidy due to valuation risk never gets discovered as securities mature and new ones are bought and the cycle keeps going on. However, at points in time, this may manifest and then impact all investors equally, whether overnight or longer-term. The one difference, however, is for an overnight investor who doesn’t automatically renew investments every day—a small sub-set admittedly of overall investor base for a liquid fund—the probability of getting caught on the day that this impact surfaces, is accordingly lesser.

With the tightening of valuation norms for short-end securities, SEBI has in effect moved to reduce the above two subsidies. Thus, with prospects of higher mark to market volatility, fund managers are likely to reduce the average maturity of liquid funds. This will, in turn, reduce the subsidy paid by longer-term investors to overnight investors. With better price discovery in daily NAV, and lower maturity of funds, the likelihood of a one-time impact to NAV on a stress day will also be lower.

However, there is a third element of subsidy as well which will also need addressing at some point in the future. This is owing to the fact that all instruments don’t have the same credit quality. One more way by which an element of subsidy gets created is by the fund manager buying differential credit quality for at least parts of the portfolio in order to increase portfolio yield.

The fund manager can control mark-to-market risk and still attempt to create a significant differentiation in portfolio yield versus overnight rates by choosing instruments of differential credit quality. This differential quality may also not be apparent immediately, given that almost all instruments held in a liquid fund may carry the highest short-term rating. However, as is well known, the highest short-term rating may correspond with a very wide band of long-term ratings.

Indeed, if the new regulation constraints fund managers from running higher maturities, some of this compromise may very well come to reflect in the credit quality of the residual book. Another reason to expect this is purely operational: banks may be unwilling to issue 30-day instruments and hence the dependence on issuances by non-bank entities may correspondingly increase. Most of this subsidy may also be inter-temporal with current returns getting subsidised potentially at the cost of future returns, should adverse credit events happen at some point in the future. In order to plug this last remaining piece of subsidy and to make the product more reflective of a very short investment horizon (including overnight), it may well be desirable to introduce equivalent long-term rating criteria for the portfolio of liquid funds.