Are liquid funds still liquid and safe?

Are liquid funds still liquid and safe 1 Are liquid funds still liquid and safe?

Liquid funds have emerged in the past few years as a perfect alternative for liquid bank savings accounts. Liquid funds are a category of debt mutual fund which invests in money market instruments such as commercial paper, treasury bills, certificate of deposits etc. Since they invest in short term instruments they have all the advantages of a savings bank account but offer a lot more. Here is why liquid funds emerge as important instruments to manage liquidity in the last few years.

  • Liquid funds gave higher rates of return than a bank savings account. For example, a typical bank savings account would pay you around 3.5% to 4%; and that too on the minimum balance between the 10th and the last day of the month. So effectively, the yield was much lower. On the other hand, liquid funds paid anywhere between 5.5% and 6.5% depending on the nature of liquid funds that you opted for.
  • Liquid funds were as safe as bank deposits. Of course, we are assuming here that liquid funds allocate money to safe instruments like the call market, treasury bills and government securities.
  • Liquid funds were extremely liquid as they could be sold and purchased at any point of time without any price damage. Most liquid funds offer same day or T+1 redemption, making them almost as liquid as a bank account.
  • Finally, liquid funds were more tax efficient. The interest on a savings bank account is taxed at your peak tax rate. If you are in the 30% tax bracket, then you end up paying 30% on interest. On the other hand, you could opt for growth plans and pay lower tax by holding it for more than 3 years. You got the added benefit of indexation. Liquid funds were also more flexible as they could be structured as systematic withdrawal plans (SWPs) to reduce tax liability even further.

Also Read: Fixed Deposits Vs Liquid Funds

SEBI changes the rules of the game

After the IL&FS fiasco, SEBI has chosen to change the rules of the game by making the regulation of liquid funds tighter and more stringent. The reasons were not far to seek. Some of the liquid funds had invested in longer tenure assets which carried higher price risk. Some of the liquid funds had also invested in commercial paper (CP) of private players, which exposed them to default risk. Some of the key measures announced by SEBI pertaining to liquid funds are as under:

  • Loss recognition in liquid funds will now have to be done on a mark-to-market (MTM) basis. In the past, only debt instruments maturing beyond 60 days had to be provided for MTM losses. In case of bonds of less than 60 days maturity, the difference between the purchase and redemption price could be amortized through the year. Now SEBI has changed the definition from 60 days to 30 days. That means any bond with maturity above 30 days will not require the liquid fund to provide for MTM losses.
  • The immediate impact of the above measure will be that liquid fund managers will be forced to reduce the average maturity profile of their liquid fund holdings to reduce their MTM liability. But, this would also mean that the yields on liquid funds will come down since yields are linked to maturity. Now, when you are parking in liquid funds, you may have to reconcile to at least 50-100 bps lower returns on liquid funds.
  • SEBI has also made the portfolio liquidity more stringent. Now liquid funds will have to mandatorily hold at least 20% of their fund corpus in cash/cash equivalents like treasury bills and repos on G-Secs. In these cases, the yields may be lower but the risk of default is zero and hence it gives greater comfort to the liquid fund investor.
  • Liquid fund and overnight funds will not be allowed to invest in short term deposits or money market instruments having structured obligations, credit enhancements or promoter pledges. We saw how these complex products led to losses in the recent past. Promoters can no longer use this route for back-door funding using promoter shares.

Have liquid funds become riskier?

On the other hand, the slew of measures announced by SEBI has actually made the liquid funds safer and more predictable. Since individuals and corporates rely on liquid funds for parking liquidity, this regulation was required. However, this will impact liquid fund returns in three ways. Firstly, the 30-day rule will shorten the maturity profile of liquid funds and that would mean lower returns. Secondly, the mandatory 20% allocation to cash equivalents reduces the leeway for fund managers. Thirdly, the restriction on structures will take away the alpha on liquid funds.

Liquid funds have also been permitted to charge exit loads to dissuade investors from trading in and out of liquid funds. The returns may be lower in the future, but liquid funds will certainly be true to their name; liquid and safe!

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