Global Outlook

SEBI’s latest move is aimed at fund houses

Contributed by Nirmal Bang

By Nirmal Bang

In the beginning of February ’10, capital market regulator Securities and Exchange Board of India (SEBI) made crucial changes in the valuation methods of liquid funds and ultra short-term funds that could hurt their current popularity in the short term. But in the long term, it is aimed at steering the industry focus more on retail than institutional investors.

From 1st July this year all debt funds will have to value their debt papers as per the prevailing market prices if they mature after a period of three months, down from the earlier six months.

The same valuation method rule will be applied to money-market instruments as well. SEBI had made this mandatory through a circular issued on 2nd February.

As a result, liquid plus schemes will become volatile depending on market swings and will no longer show consistency in increase or decrease in the net asset value under the current amortization method.

Fund houses introduced these funds in 2007 when the year’s budget increased the dividend distribution tax (DDT) for corporates from 14.03% to 28.03% in liquid funds. Ultra short-term funds were devised to provide liquidity with tax advantage.

The assets in short-term debt funds are by nature volatile, with crores of rupees flowing in and out of such funds each quarter with banks and corporates parking their excess cash in such instruments. When the markets fell in 2008 post global markets meltdown, investors made a mad rush for redemptions.

The investors who were mainly cash-starved corporates pulled out more than Rs 900 billion from debt funds, contributed to a liquidity crisis in Sept-Oct ’08, forcing the central bank to offer money through a special money market operation.

This also led to unexpected negative one-day returns from money market or ultra short-term funds run by Mirae Asset, Franklin Templeton, DSP BlackRock and Kotak Mahindra.

Further, the problem was also in the fact when debt markets turned volatile, ultra short-term funds did not reflect the reality and their net asset values (NAVs) continued to show a steady rise.

This was primarily because debt securities maturing before six months were not required to reflect their prevailing market prices. The securities used the amortization method.

For example, if a debt fund invested in a debt security with a face value of Rs 100, carrying a coupon rate of 5% per annum and matured in five months, it would have spread the total interest income of Rs 2.10 — or Rs 0.014 per day — over the debt paper’s tenure. In other words, only those securities that mature after six months would reflect market’s volatility depending on how their market prices move.

Industry sources say that SEBI’s latest move of the crackdown on debt securities is just the beginning. To ensure that the October ’08 type crisis is not repeated and corporate investors do not use the MF route to save taxes, the loopholes might be plugged, experts predict.

In fact over the past year or so banks and companies have been parking their surplus capital in income and liquid schemes of mutual funds for higher returns.

The popularity of income and liquid papers is evident from the fact that over 70% of the total assets under management of fund houses comprise such papers. They give a return of around 5% annually as compared to 4% from short-term bank fixed deposits.

Even the Reserve Bank of India raised its concerns over the fact that banks' investments in mutual funds of all types soared to Rs 1.03 trillion as on 15th Jan ’10 versus Rs 450 billion as on 2nd Jan ’09.

This in turn sparked heavy short-term debt issuances from banks and companies leading to the central bank cautioning that these cross-investments led to significant rollover risks in case of mass redemptions.

The capital market regulator now wants debt funds to value their underlying securities more realistically. They will now have to mark-to-market all those debt papers that mature after 91 days.

Money market instruments such as certificates of deposit, commercial papers, collaterized lending and borrowing offerings were not marked-to-market even when they matured after six months. Now, these too will be marked-to-market.

As most ultra short-term funds invest up to 90% of their corpus in the above mentioned instruments, they are set to become more volatile. Ultra short-term funds invest significantly in money market instruments.

Now their net asset values (NAVs) will be more volatile and they can also give negative returns on some days. However, they will be more realistically priced as most of their underlying instruments will reflect the prevailing market price.

Though the negatives seem aplenty at the moment, mutual fund industry experts are cheering the move as it is believed to be a continuation of the efforts to reduce the systematic risk arising out of the swelling corpus of these short-term funds.

There has been constant pressure on the capital market regulator to do away with the tax advantage the liquid and money market funds have over bank fixed deposits.

According to a chief executive officer of a leading fund house, SEBI’s move is to check the ever increasing size of the assets under management of liquid and ultra short-term funds.

At the end of December ’09, the assets under liquid funds and money market funds accounted for 70% or Rs 5,40,000 crore of the total industry asset under management (AUM) of Rs 7,75,525 crore.

According to the fund house CEO, due to the move to mark-to-market, the value of securities with maturity up to 182 days would ensure the liquid and ultra-short-term funds are indeed liquid by allowing them to be valued in a more transparent manner.

He also added that SEBI has initiated an effort to slowdown the large flow of institutional money into liquid funds. Although in the short run, this would lead to a drop in the AUM of the industry, in the long run this move would help stabilize the industry.

The fund industry for now is gearing up for the challenge. For starters, fund managers will have to sharpen their skills to be able to dynamically manage the duration of funds and debt papers.

Also, it is beneficial from the investors’ point of view as they would now settle for lower but more stable returns of liquid funds than high-return, high-volatile ultrashort- term funds.